I am active duty military. I purchased a home in November 2009, and lived in it until May 2013. I then converted it to a rental property. I pass the two-of-five years use-test for it being my primary home and not having to pay capital gains tax. There is a suspension period for those on “qualified extended duty” of up to 10 years for capital gains tax purposes. If I leave active duty (qualified extended duty) next year and sell the home within a year after leaving active duty, can I still claim the suspension period from May 2013 to the time that I leave active duty? In other words, can I sell the home after I am off active duty and not pay capital gains taxes?
There are two major parts to the answer of this question:
- What is effect on the five-year test period resulting from use of the military suspension?
- How much of the gain on sale is taxable as ordinary income because of depreciation recapture from the period the home was rented?
While on active duty, a service member only suspends the five-year test period to determine if he or she lived in the home for two out of the last five years. If, for example, you leave active duty in May 2019, the suspension period ends, and the five-year test period clock restarts. Given that you lived in the home from November 2009 to May 2013, and assuming you sell it in May 2020, your five-year test period would be May 2020 back to May 2009. The period of active duty from May 2013 to May 2019 that you didn’t live in the home because of qualified official extended duty is ignored for purposes of the five-year test period. Under this example, you would have lived in the home four out of the five years in the test period, and you would qualify. However, converting to a rental property complicates matters.
Since you rented your home during the suspension period and you either took or were eligible to depreciate the home as 25-year residential rental property, you must “recapture” the depreciation expense taken on the property as ordinary income on your tax return. Recapture means giving back the benefit you received by previously deducting deprecation on the rented home, i.e., the lesser of depreciation allowed or allowable.
Here is an example. Assume the home cost excluding land was $200,000, and you sell the home in 2020 for $300,000. Also, you were able to deduct $56,000 of deprecation over the seven years the property was rented ($200,000 / 25 years x 7 years). Your total gain is $156,000. Of this amount, $56,000 is taxable ordinary gain (it equals the depreciation deducted) and $100,000 is excluded capital gain under the sale of home gain exclusion rules. The gain exclusion limits are $250,000 for single taxpayers and $500,000 for married joint filers.
, Selling Your Home, provides additional information, details, and examples. Given the complexity of the situation, I recommend that you get advice from a CPA who will ask you for specific facts and circumstances in order to provide a more thorough answer.
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Answered by: Frank Scattene, CPA, is director, tax and international, with Computer Aid Inc. in Allentown, Pa.