Gain on sale... or not?

[Possi]

How long does the military have to exclude the gain on the sale of a house that was the personal home and changed to rental because of military orders?

The house was purchased in August of 1999.

In October of 2002, he got orders and was shipped out and was never sent back to that location.

He rented it out beginning in October 2002 and sold it in Sept. 2011.

He has refinanced it several times over the years.

I believe there is no salvation for this, that the gain is all taxable because of the length of time but he is saying there is a special 10 year rule that applies, making it remain as personal property.

I have never heard of this, and I cannot find any such exception. Is he right?

[ChEAr$]

If any non military person converts a former personal residence into rental property, he can't escape tax on the gain. Why should a military person be able to do that?

If your client is that military member, ask him for chapter and verse, i.e. IMWTK.

[Lion]

Practical Tax Expert, §45,820.10, Exclusion of Gain on Sale of Residence

Federal Tax > Federal Tax Editorial Content > Practical Tax Expert > Special Taxpayers > Military Service Members > §45,820 Miscellaneous > §45,820.10, Exclusion of Gain on Sale of Residence

All taxpayers may exclude up to $250,000 of gain from the sale or exchange of their principal residence (joint filers may exclude up to $500,000). Code Sec. 121. See the discussion beginning at §1,601. The exclusion is subject to an ownership and use test in which the taxpayer must have owned and used the property as his or her principal residence for at least two years during the five-year period that ends on the date of sale of the property.

A special exception to the two-out-of-five-year rule is provided for uniformed service personnel called to active duty away from home on "qualified official extended duty."Code Sec. 121(d)(9). The exception is also allowed for members of the U.S. Foreign Service and intelligence community employees on such extended duty. In such circumstances, the taxpayer may elect to suspend the five-year test period. The maximum length of the suspension is ten years, and it may only be made with respect to one property. If the election is made, the five-year period ending on the date of the sale of a principal residence does not include any period up to ten years during which the serviceman or woman, or his or her spouse, is on qualified official extended duty. An election may be revoked at anytime.

Qualified official extended duty is defined as any extended duty while serving at a duty station that is at least 50 miles from the taxpayer's principal residence or while residing in government quarters under government orders. Extended duty is any period of active duty pursuant to a call or order to such duty for a period in excess of 90 days or for an indefinite time.

Reduced maximum exclusion rule. A taxpayer who fails to meet the ownership and use requirements as a result of a change of place of employment, health, or unforeseen circumstances, including military assignments, might be eligible for a partial gain exclusion. The amount of the available exclusion is equal to the amount of the applicable exclusion ($250,000 or $500,000) multiplied by the ratio of:
(1) the shorter of (a) the aggregate periods during which the ownership and use requirements were met during the five-year period ending on the date of sale or (b) the period after the date of the most recent sale or exchange to which the exclusion applied, over
(2) two years. 5
See §1,620. In applying this provision, the five-year period is suspended during the time that the taxpayer or the taxpayer's spouse is on "qualified official extended duty" as defined above. Code Sec. 121(d)(9)(A).

Non-qualified use. For sales and exchanges after December 31, 2008, gain from the sale of a principal residence that is allocable to periods of non-qualified use is not excluded from the taxpayer's income. Code Sec. 121(b)(4)[(5)]. A period of non-qualified use with respect to a piece of property is any period, other than any period before January 1, 2009, during which the property is not used as the principal residence of the taxpayer, the taxpayer's spouse or the taxpayer's former spouse.

Comment
Thus, homeowners who use their home as a vacation home or for rental for some of the time will no longer be able to exclude the portion of gain allocated to such non-qualified use.

There are several exceptions to the general definition of period of non-qualified use. One exception applies to any period not exceeding an aggregate period of 10 years during which the taxpayer or the taxpayer's spouse is serving on qualified official extended duty as defined above.

Compliance Note
An active member of the uniformed services who temporarily rents out his or her principal residence is not required to file an information return with the IRS to report payments he or she makes to a service provider in the course of earning rental income. See §39,105.07.

Footnotes
5 Code Sec. 121(c); Reg. §1.121-3.

[KathMorgan]

Even with the "ten year" execption....

He doesn't meet the requirements since if you go back 10 years from the date of sale he misses the 2 out of five requirement, I think. The 10 years goes back to Sept 2001 and he began renting it in Oct 2002. He can't have his cake and eat it too, his time period is either five year from the purchase date in Aug 1999 or it's 10 years from the transfer date in Oct 2002. No mixing and matching.
And this all only applies in the first place if that home happened to be in his legally indicated Home of Record for the military. So if it was just at a place he was stationed during his career and not his Home of Record (which is usually where he enlisted in the first place) then the exception doesn't apply anyway.
Also if in the last ten years since he got transferred he bought another "primary residence" at another duty location he's out of luck as well.
I've had this fight with the IRS and lost.

Kathy

[joanmcq]

But doesn't the suspension make it effectively a 2-out-of-10 year period? I haven't come across this yet, but that was what I was led to believe by my update classes.

[ChEAr$]

he's really going to be shocked at the recapture of depreciation.

I don't envy Possi trying to explain that to him.

[Possi]

No kidding

he's really going to be shocked at the recapture of depreciation.

I don't envy Possi trying to explain that to him.

Not a fun day at all. The depreciation recapture is absolutely killing him, and he doesn't even KNOW it yet!

Now, slicing and dicing the dates, I got back with him on the exact date he purchased the home. He had to go to public records for the information because he doesn't have the closing papers...

Actually purchased on 10-28-1999.

Placed in service for depreciation is 10-24-2002.

So, he lived there a hair under 3 years before being stationed away.

So he did live in it for over 2 years before being stationed away, but even if he didn't, Page 12 of Pub 3 states that "you may be able to meet the 2-year use test even if, because of your service, you did not actually live in your home for at least the required 2 years during the 5-yr period ending on the date of sale."

So, getting back to my guy, if we choose to suspend the 5-year period to 10 years, would the suspension be from 10/2002 (time of rental) to 10/2012, therefore MEETING the suspension period for the gain on the sale? (Depreciation notwithstanding)

????????????? do I have this????????????????

If so, I am reflecting the sale of the house on the Sch D, sale of personal residence. The gain on the home is excluded, BUT the $71k in recaptured depreciation will mean he owes 20k as his bottom line this year.

That makes sense to me, logically. I hate having to tell this Military Commander heading to Afghanistan THIS WEEK...
man, what a bad day... for him...

[Gary2]

Just to be clear, the depreciation (or at least the bulk of it), isn't recaptured. But rather, it's unrecaptured 1250 gain, which can't be excluded from income, but is taxed at a maximum capital gains rate of 25% (as opposed to recaptured depreciation, taxed as ordinary income).

[Possi]

Sch E

So, I should be reflecting the sale on a Sch E worksheet, with no gain on the sale because of the exclusion, and only taxing the depreciation????

I feel like I'm talking out of both sides of my mouth...

[joanmcq]

No, since it's a rental at the time of sale, it's reported on the 4797. You might have to tweak (override) your software if the exclusion applies.

And the sale will free up any suspended passive losses if there is any.

[Possi]

Ok...

No, since it's a rental at the time of sale, it's reported on the 4797. You might have to tweak (override) your software if the exclusion applies.

And the sale will free up any suspended passive losses if there is any.

I'm going to work on that and see what my final answer is... I'll post...

[Possi]

whew

I'm glad that is over.

Bottom line is he owes just under $12k. Better than I expected.

Worse that I expected was checking his 2008-2010 returns. DYI double-dipped mortgage interest in 09 and 10, hitting the Sch E and the Sch A.

[RitaB]

Oops

I'm glad that is over.

Bottom line is he owes just under $12k. Better than I expected.

Worse that I expected was checking his 2008-2010 returns. DYI double-dipped mortgage interest in 09 and 10, hitting the Sch E and the Sch A.

Oops, only clergy get to double dip on mortgage interest.

[KathMorgan]

Happens all the time

Glad you got the ddisposition fixed up. Doing it on the 4797 is the way to go because it will carry to the Sch D and/or 1040 as appropriate for the right amount that is taxed at the different rates.
As for the 2009 and 2010 returns and the double dipping, that is probably the number one thing I see on DIY returns with rent houses. At least adding the depreciation he didn't take but had to recapture will offset that a little bit.

Kathy

[joanmcq]

And I'm surprised he hasn't gotten a notice for 2009 yet. The AUR computers are set up to catch that, and saw a lot of CP notices for those errors once the mortgage interest became a 'flag' in the AUR system.