Selling a rental house that was converted from personal use due to military orders.

[Bryan_Peterson]

My wife and I had a house built in 2006 for $206,100.  In 2010, I was transferred to another state and have been away ever since. We have been renting the property since I left. We currently owe about $148,000 and have a it under contract for sale at $255,000.

My questions are:

1) Does the military clause that allows us to the suspend this five-year test period for up to ten years for capital gains taxes apply? My understanding is that if we go back ten years and then look at the previous five years (2011 back to 2006) we would qualify since we lived in it from 2006 to 2010. This would allows us to take the up to to $500,000 deduction from me and my wife and not have to pay taxes on the sale.

2) Since I have been depreciating the house as a rental for the last ten years, how does that affect the taxes to be paid if we do in fact have to pay anything?  

Thank you,

Bryan

[DanielV01]

Here are your answers:

1.  Yes, with a caveat regarding depreciation (see answer 2).  As you had to move via PCS orders, your test period for exempting gain from the sale of a home goes from 2 years in the previous 5 years to 2 years in the last 15 years.  This website provides additional information:  Military Extensions & Tax on Selling a Rental Property

2.  Your sale is still subject to depreciation recapture.  

Let me illustrate using similar numbers to what you present.  You purchase the home for $200,000, and sell it for $250,000.  (How much you owe on the home does not come into play in the calculation).  Because you've been renting the home for 10+ years, you have been taking depreciation on the home (or could have taken depreciation; we will assume you did for this example).  Let's say the depreciation taken was 70,000 (close to accurate).  Since depreciation reduces basis, the basis of the home you purchased is now 130,000, which makes the gain from the sale at $120,000.  Since you lived in the home from 2006 to 2010, you are allowed to fully exempt this gain.  However, since the gain from the sale was greater than the depreciation recapture, you will claim the $70,000 as ordinary income (not capital gains), which will be subject to your regular tax bracket tax rates.