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In the military, there are many reasons for selling your home. You can sell for any of the following reasons:
- buying a bigger home
- because it makes financial sense to do so
Let’s take a look at five tax considerations you should account for when selling your home.
#1: Realized gain from selling your home
When selling your home, or any real estate, the IRS definition of realized gain means a lot of things you might not have considered. According to the IRS, the basic formula for calculating your realized gain is:
Sales price – selling expenses – adjusted basis.
Since you already know the sales price, 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:
- Seller’s closing costs
- Real estate commissions
- 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.
- Adjusted basis includes:
- Original purchase price of your house
- Fees incurred during home closing (such as title insurance, legal & recording fees, or survey fees).
- Major improvements
- 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). You can find 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.' This publication is user-friendly and available online.
#2: Section 121 tax exclusion
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.
Ownership requirement: If you owned the home for at least 24 months of the 5 years leading up to selling your home, you meet the ownership requirement.
Use 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, the use requirement applies to each of you. This requirement applies even if only one person meets the ownership requirement to qualify for the $500,000 exclusion.
#3: ‘Stop the Clock' clause
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 use requirement for up to 10 years if you are on qualified active duty & ordered to move at least 50 miles from your residence. When combined with the 5 year test period, ‘stop the clock' can encompass up to 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. This is an important consideration for your transition.
For example, you buy a home in 2005, then live in it until 2007. In 2007, you receive orders to move outside of your permanent station. Normally, the IRS would require you 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.
#4: Capital gains rates
If your sales price is more than your basis and your selling expenses, then you might realize capital gains. Capital gains are either short term, or long term in nature, and depend on how long you've owned the home.
If you've owned your home for a year or less, the IRS will treat your gain will be treated as short-term capital gain. This is the same as your ordinary income rate.
If you own the home for at least a year and a day, they qualify for treatment as long-term capital gains rates. These rates, which range from 0% to 23.8%, are based upon your marginal income tax rate. However, long-term capital gains rates are always preferable to your ordinary income tax rate. 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.
#5: Depreciation recapture
If you rented your house to a tenant, as many people do when they PCS, the IRS will hold you liable for what is known as recaptured Section 1250 depreciation. Normally, when you own a residential rental property, the IRS allows you 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.
- You may want to seek the advice of a tax professional, such as an enrolled agent or CPA. A tax professional will help you properly calculate your tax liability on the sale.
- You should have a tax professional complete your tax return for the year you sell your home. This will ensure you’ve properly paid your taxes.
This article is not an adequate substitution for unbiased professional advice. The unique circumstances of your personal situation should dictate the terms of your professional advice. Before you make any major decisions, you should sit down with a fee-only financial planner in your area. A fee-only financial planner can help you take into account all of the things that affect your financial situation.
Forrest Baumhover is a Certified Financial Planner™ and owner of Westchase Financial Planning, a fee-only financial planning firm in Tampa, FL. As a retired naval officer, Forrest helps veterans, transitioning servicemembers and their families address the financial challenges of post-military life so they can achieve financial independence and spend more time doing the things they love.