Military Exlusion for Capital Gains on sale of home

Since your residence became a rental, tax software often struggles to reconcile the rental period (depreciation) with the military suspension of the 5-year rule. Here is why your gain is likely showing up on Schedule D and how to fix it in TurboTax Desktop.

There are two main reasons why a "tax-free" sale still hits Schedule 😧

1. Depreciation Recapture: Even if the home sale is excluded under Section 121, any depreciation you claimed (or were entitled to claim) while it was a rental cannot be excluded. This portion of the gain is "recaptured" and taxed as ordinary income (up to 25%).
2. Unchecked Military Election: TurboTax might not be automatically applying the 10-year suspension rule. Without this specific "election" checked, the software sees you haven't lived there for 2 of the last 5 years and defaults to taxing the gain.

Since you are using the Desktop version, you have the advantage of Forms Mode, which is the fastest way to see where the "leak" is.

Step 1: Check the "Sale of Home Worksheet"

1. Switch to Forms Mode (click the "Forms" icon in the top right). 
2. In the left-hand list, find and click on Sale of Home Worksheet.
3. Scroll down to the section regarding Qualified Official Extended Duty (Military).
4. Ensure the box is checked to elect to suspend the 5-year period. This tells the software to look back up to 15 years instead of 5 to meet the "lived in it for 2 years" requirement.

Step 2: Address the Rental Component (Non-Qualified Use)

If you rented the home after you lived in it, the military exclusion usually covers the gain. However, if the software is asking about "Non-qualified Use":

1. Good News: For military members, periods of "non-qualified use" (rental periods) do not count against you if they occurred after the last day you used the property as a main home, provided you are on qualified official extended duty.
2. In the Step-by-Step interview, under the "Sale of Home" section, ensure you accurately mark the dates you moved out due to PCS orders.

Step 3: Identify Depreciation Recapture

1. Look at Schedule D or Form 4797.
2. If the amount being taxed matches exactly the depreciation you took over the rental years, that amount is legally taxable and cannot be excluded.
3. If the amount being taxed is the entire gain, then the 10-year suspension election (Step 1) wasn't properly triggered.

Quick Summary of the "Military Rule"

1. Under IRC Section 121(d)(9), you can suspend the 5-year ownership/use test for up to 10 years while on qualified official extended duty (at least 50 miles away or in Gov housing). This effectively gives you a 15-year window to meet the "lived in it for 2 years" rule.

If the Step-by-Step interview keeps looping you back to a taxable result, go to the Home Sale Worksheet in Forms Mode and manually check the box for the Military Election. This usually forces Schedule D to update and show the exclusion code "S" (for Section 121 exclusion) on Form 8949, which flows to Schedule D as a $0 taxable gain.