Paycheck Chronicles

From The Mailbag: Capital Gains Exclusion vs. Extension

Selling a house.  You know it is hot on my mind right now.  Seems I'm not alone.  This week's mailbag question is about taxes on house selling.  But before we get into the question, I must give a warning:  this information is for educational purposes only.  Every person has a unique tax situation, and this post can not and does not try to give specific advice about your situation.

Dear Kate,

I'm confused about the tax exemption for military selling houses.  Can you please explain it to me?

Bob

When it comes to the Internal Revenue Service, little details can make a big difference.  And when it comes to taxes, a big difference can mean a lot of money.   You want to be sure you are paying as few taxes as legal and right, but in order to do that, you need to understand our tax code.  In order to understand it, you have to understand the terms being used.

When military families sell a house, there are two different sets of rules that may help them reduce or eliminate any capital gains taxes on the sale of their house.  One set of rules is the capital gains exclusion, the other set is the military extension for that exclusion.  In most cases, it doesn't matter if you get those terms exactly right, but it can be confusing and may make the job of preparing your taxes harder than it has to be.  And, seriously, who wants to make their taxes harder than they are?

Dear Bob,

I'd be glad to help!  There are a couple of types of taxes that you can encounter when you sell a house:  capital gains taxes, depreciation recapture tax, and state taxes (which may vary depending on the state in which the property is located.)

Depreciation recapture taxes apply to those folks who have rented the property at any point prior to selling.  Depreciation recapture is a slightly complicated concept and you definitely want the help of a professional with this.  (I'm trained to do taxes, and I still don't want to get near this.)  If you have a rental, and you don't understand depreciation recapture, you need to learn about this right now.

State taxes, as I said before, are going to vary from state to state.  This is really something that you need to find out at your local level.

The big worry for most folks is capital gains taxes. When military families sell a house, there are two different rules that may help them reduce or eliminate any capital gains taxes on the sale of their house.  One rule applies to everyone, military or not, the other rule extends the first rule for military families who don't live in their home due to Permanent Change of Station (PCS) orders away from the area.

Capital Gains Rules For Everyone

Our country's tax code has several provisions that encourage home ownership.  One of them is the exclusion that protects a portion of the profit made on the sale of a house, if you meet certain criteria.   Under this capital gains tax exclusion, you may exclude up to $250,000, ($500,000 for a married couple) of profit that you make on the sale of a house as long as it was your primary residence for two of the previous five years.  (This is commonly called the 2-of-5 rule.)

For example, if you lived in your house for three years, and sold, you could exclude up to $250,000

If you lived in the house for less than 24 of the 60 months prior to the sale, you may be eligible for a pro-rated exclusion if your move was due to a "work, health, or other

The Military Extension

If you're military (or a civilian in certain parts of the intelligence community, or in the Peace Corps,) you may get an extension of the timeline to qualify for the capital gains exclusion.

When you receive PCS orders to move away from the property, you may "suspend" up to ten years of time, meaning that you must have occupied the property for two out of the previous fifteen years, if you were eligible to suspend the full ten years of time because you were stationed away from the property for ten years.  This is called an extension of time

For example, let's say you bought a house in June 2007 and moved on PCS orders in December 2010.  Under regular rules, you would have to sell by December 2013 to use the capital gains exclusion.  December 2008 to December 2010 is your two years of occupancy, and the five year period ends on December 2013.  However, because you moved on PCS orders, you can suspend up to ten years of time, meaning you have until December 2013 to sell and use the capital gains exclusion.

However, it is super-important to note that you can not suspend time on more than one property at a time.  In the example above, let's say you purchased at your new duty station in January 2011, moved again in June of 2013, and again rented that house out.  When you eventually go to sell, you can not suspend the same time on both houses.

You can read the full guidelines in IRS Publication 523.

Thanks for writing in.  This stuff can be confusing!

Kate

I think there's a chance that I told Bob more than he wanted to know, but that's OK.  This stuff is confusing.  The more you know, the better you can work with your tax professional to make sure things are handled correctly.

 

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