In the military, when you make the decision to sell your home, it can be for any number of reasons: relocation, buying a bigger home, downsizing, retirement/separation, or because it makes financial sense to do so. Whatever the reason for selling your home, let’s take a look at three tax considerations you should account for:
Your realized gain
When selling any real estate, the IRS definition of realized gain accounts for many things you may not have thought about. According to the IRS, the basic formula for calculating your realized gain is: Selling price – selling expenses – adjusted basis. This means you need to calculate two things: selling expenses & basis. Proper calculation of selling expenses & basis could mean the difference of thousands of dollars in tax liability.
Selling expenses include any seller’s closing costs, real estate commissions, and any other related selling costs. You should comb through your closing documents to make sure you’ve properly accounted for all selling expenses. Do not include city & county property tax, but do include transfer taxes, if applicable.
Basis includes the original purchase price of your house, plus fees incurred during home closing, such as title insurance, legal & recording fees, or survey fees. Basis also includes the cost of any major improvements, renovations, or system replacements. The IRS makes a clear distinction between repairs that are a normal part of keeping a home in good condition (such as repairing leaks), and an improvement (such as replacing the plumbing system).
For a comprehensive list of what can & cannot be included in selling expenses or basis calculation, you can refer to the IRS Publication 523, ‘Selling Your Home,’ which is user-friendly and available online.
Under Section 121, the IRS allows a taxpayer to exclude the first $250,000 of capital gain ($500,000 for married couples filing jointly) on the sale of their primary residence if they meet certain ownership and use requirements. If you owned the home for at least 24 months of the 5 years leading up to the sale, you meet the ownership requirement. If the home was your primary residence for at least 730 days of the previous 5 years, you meet the use requirements. If you’re married filing jointly, you must each meet the use requirement, even if only one person meets the ownership requirement to qualify for the $500,000 exclusion.
Since PCS moves are a normal part of military life, IRS Publication 523 contains a specific clause for military personnel, referred to in IRS Publication 523 as “stop the clock.” What this means is that you can suspend the two year requirement for up to 10 years if you are on qualified active duty & ordered to move at least 50 miles you’re your residence. When combined with the 5 year test period, this can be a total of 15 years. Keep in mind, this only applies if you meet the criteria for ‘qualified extended duty.’ If you end up moving back within 50 miles of the house, or are no longer on active duty, this clause is no longer in effect.
For example, you buy a home in 2005, then live in it until 2007, when you are ordered to move outside of your permanent station. Normally, you would be required to sell by 2010, but with the 10 year suspension, you can sell by 2020 and still meet the use requirements. IRS Publication 523 contains more details.
There can be two tax calculations to consider, depending on whether you rented your house out before selling.
Whether you rented or not, if you owned the home for at least a year and a day, any gains are taxed at long-term capital gains rates, which range from 0% to 23.8%. Otherwise, your gains are taxed at short-term capital gains rates, which are the same as ordinary income rates. Long term capital gains rates calculations are also based upon a taxpayer’s marginal tax bracket, but are more favorable. For example, a taxpayer in the 15% tax bracket will pay 0% on a long-term capital gain. If you’re considering the sale of your home and project a profit within a year of purchase, you may want to consider whether you can sell it in a manner that qualifies the sale as a long-term gain. However, if you’re selling your principal residence for a loss, you do not qualify for any type of deductible loss.
If you rented your house to a tenant, as many people do when they PCS, you may be liable for what is known as recaptured Section 1250 depreciation. Normally, when you own a rental property, also known as Section 1250 (real property that doesn’t qualify under any other section), you are allowed to depreciate the costs of the home over a 27-½ year useful life. This depreciation is normally captured on Schedule E of your 1040, and is subtracted from your rental income. When selling this property, the IRS will expect you to ‘recapture’ this depreciation & pay a flat 25% tax on it.
Calculating the taxable gain or loss from a home converted into rental property can become fairly complicated. When you sell such a property, you will want to do two things. First, you may want to seek the advice of a tax professional, such as an enrolled agent or CPA to make sure you properly calculate your tax liability on the sale. Second, you should have your taxes professionally prepared for the year you sell your home to make sure you’ve properly paid your taxes.
This article is by no means an adequate substitution for unbiased advice, which should be tailored to the unique circumstances of your personal situation. Before you make any major decisions, you should sit down with a fee-only financial planner in your area so that they can help you take into account all of the other factors that can affect your planning decision. Having a relationship with a trusted professional who can help account for life’s changes is the best way for you to put together a plan that achieves your retirement goals.
As always, this blog serves to answer your questions and address concerns. If you like this blog, please forward it on to other people who may benefit. If you have issues or concerns, or if you have a question you’d like me to answer, please feel free to contact me. You can reach me through my website, or via email. In the meanwhile, take charge of your life!