Military capital gains exemption after sale of property

[foxydeuce]

How do I account for military exemption for capital gains after sale of rental property?

[KristinaK]

There is an exclusion from paying capital gains on a primary residence. You must have lived in it for two out of five years. There are circumstances when the military can suspend the five-year period. You can read about it here. 

However, this does not apply to rental property. 

[Opus 17]

There is no exemption.

What you can do is extend the deadlines.  Normally, you can exclude the first $250,000 of gain from taxes (or $500,000 if married filing jointly) as long as you owned the home at least 2 years and lived in the home at least 2 of the past 5 years.  Meaning basically, you must sell the home in 3 years or less after you move out.

However, if you move out due to military orders or certain other foreign service, you can suspend the time limits for up to 10 years.  Meaning, you could sell the house up to 13 years after you moved out and still claim an exclusion of $250,000 or $500,000 of capital gains.

You still pay tax on the rest of the capital gains, and you have to pay depreciation recapture tax on the portion of the capital gains that comes from the depreciation you claimed or could have claimed while the home was a rental. 

[sjbaker02]

And how do we "trick" TurboTax into knowing that I can "lookback" further than 5 years to exclude capital gain?  (I was military and moved because of orders)

[ErnieS0]

You do not need to “trick” TurboTax. The program includes questions about the military.

1. Type home sale in Search (magnifying glass) in the upper right corner
2. Tap Jump to home sale
3. On “Sale of Your Main Home,” say YES
4. Enter your sale and purchase info
5. On “Time You Lived In Your Home, say NO to Did you live in tleastome for at lest two years (24 months) since December 31, xxxx?
6. On “Reason for Sale” select Other reasons, then Continue
7. On “Other Reasons for Sale, select Military, foreign service, intelligence community employee, Peace Corps, then Continue
8. On “Member of Military or Foreign Service, tap YES to Using these special rules, did you live in the home for at least 24 months during your qualifying period?

TurboTax will exempt up to $500,000 if married filinig jointly or $250,000 if filing single.filing

Thank you for your service.

[ebot]

What if it's a triplex and active duty military servicemember lived in the "owner's unit" (or any of the units for that matter)?  Wouldn't the 2-of-last-5 rule be 2-of-last-15 for active duty military apply to the owner's portion at least?  I assume this would be determined by market rental income of the unit occupied relative to the market rental value of the entire triplex...1/3 for example (if all 3 units were considered equivalent)...or some minor alteration of that for relative market rent value of the occupied vs other units. No?

[Mike9241]

i think you may be misapplying the rule for suspending the use test. for up to 10 years you can suspend the five- year test period for ownership and use. (IRC 121(d)(9) and (12)). This election is available for any period that you are on qualified official extended duty QOED).  QOED is any period you are called or ordered to active duty for more than 90 days (including an indefinite period) you must also 1) be serving at a duty station that is at leat 50 miles from your main home OR 2) residing in government quarters under government orders. there are also rules for who is eligible.

it seems you're saying you have lived in that property which you owned for the entire period. in this case the regular rules for home sale exclusion apply. if you own the property and live in 1 unit as your principal residence meeting the ownership and use tests, the HSE only applies to your unit only. Upon sale of the property the other units would be treated like a vacation home - not eligible for the exclusion. As rentals depreciation allowed or allowable on the other two units would be subject to recapture. I have no advice on how the HSE exclusion would apply if during the 5 years you before sale you lived in different units as your principal residence. 

allocation of sales proceeds would be based on the relative Fair Value of the units. you may want to use a pro to get  a valuation. 

[Opus 17]

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@ebot wrote:

What if it's a triplex and active duty military servicemember lived in the "owner's unit" (or any of the units for that matter)?  Wouldn't the 2-of-last-5 rule be 2-of-last-15 for active duty military apply to the owner's portion at least?  I assume this would be determined by market rental income of the unit occupied relative to the market rental value of the entire triplex...1/3 for example (if all 3 units were considered equivalent)...or some minor alteration of that for relative market rent value of the occupied vs other units. No?

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Don't confuse two sets of rules.

For selling a home that is a duplex or triplex (ignoring the military part) you can claim the exclusion on the portion that you occupied as your personal primary residence.  You must have a reasonable basis to allocate the gain, usually on a square foot basis.  

Separately, when you sell your personal home as a member of the military, you may be able to extend the deadlines for the exclusion, regardless of what kind of home it is, following the normal rules.

Putting them together, for example:

You buy a triplex for $100,000 and on a square foot basis, you assign a cost basis of $40,000 to unit A, and $30,000 to units B and C.  You live in unit A as your main home for more than 2 years.  You are then deployed overseas for 7 years.  During the deployment, you rent out unit A.  You now sell the triplex for $400,000.  Using the same square foot basis, $160,000 is assigned to unit A.  For the sale of units B and C, your capital gains are fully taxable.  There is no military benefit or gains exclusion for rental property.   Part of the gain is depreciation recapture and part of the gain is long term capital gains.  For unit A, you can apply the gains exclusion to your $120,000 of capital gains.  However, you must still pay depreciation recapture tax on the depreciation you claimed or could have claimed on unit A while it was a rental.  

[ebot]

Thanks so much to both of you - Opus & Mike.  This is so interesting! lol
Seriously though - HUGE help helping me wrap my head around this.

IF you're in a glutten-for-punishment kind of mood...below I'll summarize estimated numbers for our ACTUAL situation.

Still active duty currently.

2003-2005: Purchased triplex for $500k...lived there 1st 3 years until I had to PCS.  Lived in the "owner's unit" (rented it out after we PCS'd) and have always rented the other 2 units.

I've always considered our "owner's unit" as about 50% the property value...biggest, nicest, highest market rent.

2005-2012: served in another state.

2012-2014: PCS'd back to the region but duty station was ~90min drive away, so lived in the owner's unit again 2012-2014 and extreme-commuted (sometimes stayed 1 night/week at local base to make it more bearable).
(Therefore I assume we'd need to sell by 2027 to get the full military cap gains tax exemption).

2014-present: Same duty station, but we moved to live closer to work.

Depreciation:(always MACRS) ~$131k (see question below).

Cost basis: $500k-$131k = ~$370k (I think that's how it works).

Sell: $1.1M? May be able to sell for $1.1M - ~$100k for all expenses of sale.

Capital Gain: ~$1M = $300k = $700k.

Exemption: ~50% (owner's unit) of $700k = $350k (is that right)?

Taxes: Federal 20% bracket + 3.8% investment tax applies + 9.3% vs 4% CA(?)
QUESTION: Our rental property's in CA, so we file a CA 540-NR form for it every year, so I assume we'd have to pay the 9.3% but rental is our only CA income (maybe $20k/yr) as our true domicile is a tax-free state....if it's based on our CA rental income only it's likely 4%)
...So, 33% or 28% (ish).
I'll assume ~28%.

QUESTIONS:
$700k cap gains x .33 = $196k cap gains tax bill (Military tax exemption would reduce that to ~$98k?)??
____________________
QUESTIONS: 

How do I get precise numbers for the depreciation and improvement costs over the years?  Turbotax has kept a list in Rental "Assets" (improvements). It shows 2013 I had  $30k Sec179, $4k Special Depreciation, $8 Depreciation and "Prior Depreciation" $123,594, so I should be around $131k total depreciation so far, correct?

And I assume the depreciation logged in TurboTax accounted for the years we lived there (is that even relevant)?

How does one prove they resided in the property for the 2 years?  I assume proof's only needed if audited(?).  We refinanced the mortgage while living there 2012-2014, so that reflected the property address.  I also should have:
Copy of old drivers license and car registration with that address.
Military PCS orders (to the region).
Utility bills with that address (might be able to find).
What else might be requested?

("PCS" = Permanent Chane of Station, i.e. the military moved me)

[Opus 17]

I'll try to hit the highlights but you may wish to speak to an accountant.

You should have been keeping records of your depreciation yourself.  That kind of tax paperwork you need to keep as long as you own the house, even though there is a general rule that most tax papers can be discarded after 6 years, for houses the rule should be, keep your tax papers as long as you own the house plus 6 years after you sell.  You can get copies of your tax returns from the IRS for 10 years, I think. 

If you moved out on (for example) July 1, 2014, then the 5 year rule means that you would have to sell by July 1, 2017. The 10 year suspension on extended duty gives you until July 1, 2027.

If you are single, and you qualify for the exclusion, you can exclude the first $250,000 of capital gains from taxation.  The trick is to figure out what the gain actually is.  Also, any gain attributable to the period of time between 2005 and 2012 is non-qualified for the exclusion. This rule is not currently described well in publication 523, but it arises from the fact that if you move out, then move back in, you can't get the exclusion for that "out" period because the IRS doesn't want an absentee landlord to be able to convert all their gain to an exclusion by moving back briefly.  As long as you don't move back before you sell, the period of time from 2014-2027 is qualified.  However, if you do move back, all that gain becomes non-qualified as well, so if you really want to use the exclusion, you need to sell without moving back in. 

To calculate the tax consequences, treat the property as two separate properties, one all-rental and one partly personal. Given your figures:

On the rental units, your cost basis is $250,000, depreciation is $65,000 and selling price is $500,000 after adjustments.  (But beware what adjustments you claim, some web sites are quite wrong about what is allowable.)  Capital gain on the rental side is $315,000. The first $65,000 is taxed as depreciation recapture (max of either 22% or 25%, I forget right now) and the rest is taxed at 15% or 20% for long term capital gains (depending on your other income).

On the owners unit, your cost basis is $250,000, depreciation is $65,000 and selling price is $500,000 after adjustments.  You owned the property 24 years, but 7 year are non-qualified, so only 17/24ths of the gain (70.8%) is "qualified".  Your overall gain is $315,000.  The first $65,000 is taxed as depreciation recapture.  Of the remaining $250,000 of gain, $177,083 is "qualified". Since $177,083 is less than the $250,000 exclusion, all of the $177,083 is excluded from your taxable income.  The $72,916 of non-qualified gain is taxable as long term capital gains.

So in the overall deal (bought for $500,000, sold for $1M net, depreciation of $130,000); you will pay depreciation recapture tax on $130,000; long term capital gains on $322,916, and exclude $177,083.

I think.

Because this property is located in CA, you must file a CA state income tax return to report the taxable part of the income ($130,000 plus $322,916) and pay CA tax, because this is considered California-sourced income, even though your permanent residence is not in California any longer.  CA doesn't have a discount capital gains tax rate, so it will be taxed in CA as ordinary income. (But CA does respect the capital gains exclusion which is $177,083 in your case.)

[Opus 17]

I just realized my calculation is in error by the fact that the depreciation is not spread out evenly over the 3 units.  Of the total $131,000 depreciation over the entire property, there was no depreciation taken on the owners units for the years that you lived in them as your personal residence (2002-2005 and 2012-2014). An extremely rough guess would put the depreciation on the rental units at $75,000 and on the owners unit (for the years it was rented) at $55,000.  Don't ask me how I calculated that because it's probably wrong, you should be able to come up with accurate figures from your records.  But you can re-run my original calculations with the revised depreciation amounts.

(Basically, treat the sale as the sale of two properties, one that was always a rental, and one that was partly a rental and partly personal. Keep the calculations separate the way I did and then add everything together at the end.)

[ebot]

Wow!  

Thanks Opus!

I guess this will be tricky to enter into TurboTax.  Maybe there are some fields I could explain my calculations.

[Opus 17]

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@ebot wrote:

Wow!  

Thanks Opus!

I guess this will be tricky to enter into TurboTax.  Maybe there are some fields I could explain my calculations.

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In general, you just report the final outcome, but save your records in case of audit.

Treat the sale as two separate properties.

For sale of rental property (the 2 rental units), there is a module in Turbotax for this, I think you report on schedule E (rental), and that will automatically flow to schedule D (capital gains).  You will be asked about cost basis, selling price and depreciation, some of which Turbotax may already know, and some of which you may need to add.

For sale of the owners unit that was partly rented and partly used as a personal residence, I believe you will use the program module for "sale of your personal home."  I believe this includes an interview that will cover prior rental use, and the non-qualified use period.  However, I have not used these sections of the program myself.  You can always create a dummy account (different user name and password from your real account) and make a practice return in Turbotax Online to see how it works.  Turbotax online is "free to start" and you only pay if you need to actually file the return, which you won't in this case.  (Turbotax online is only for the current tax season 2023, so whenever you do sell your home you will have to prepare your official return in that year's version of Turbotax.)

@Critter-3 , @Hal_Al , @rjs  any further guidance on how to report in turbotax?