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30 September 2015

virginia beach tax preparation military tax break rentalI was on active duty with the US Navy for just under 24 years. During my service we relocated 7 times, finally ending up in Virginia Beach for my last three tours and retirement. (We like it here.) I was actually fortunate compared to many of my fellow service members. Most of my friends were moving more often than I was. Military families move a lot.

Moving that often makes home ownership a frightening prospect. You seem to just get settled and you're moving again. You have to put your house on the market and hope it sells for a price that doesn't wreck your family finances, or you have to deal with leasing it to someone that you hope takes decent care of your biggest investment. Then, when your house no longer qualifies as your primary residence, you end up owing capital gains taxes when you sell it. Many military families prefer to rent rather than buy just to limit the unknowns to their already strained family budget.

However - President Bush signed a law in 2003 that took some of the scariness out of home ownership for military personnel, If you haven't heard about it you may want to keep reading. It can be worth some decent money.

The Military Family Tax Relief Act, as it was called, suspends the primary residence use test rules for military personnel for up to 10 years. Under the use test rules, in order to qualify for the capital gain exclusion for the sale of your primary residence you must have lived in the house for at least 2 of the 5 years immediately prior to the sale. With the 10-year suspension under the Military Family Tax Relief Act you can meet the use test if you lived in the house for 2 of the 15 years immediately prior to the sale. To qualify for the suspension you must be on PCS orders more than 50 miles from your residence, or relocated to government provided housing.

I think an example is the best way to explain what all of that means. The couple pictured above are Duane and Lareese. I worked with Duane in 2011 when I was deployed as a civilian. I used their names and picture, but have completely manufactured the facts below in order to illustrate the specific tax benefit.

Scenario: Duane and Lareese are married. Duane is active duty military, stationed in Virginia Beach. They purchase a house for $250,000 and live in it for nearly 3 years and then Duane receives PCS orders to the west coast. They could sell their house for $250,000 and (more or less) break even, or they could rent it. Duane and Lareese decide to become landlords and lease their home to another family. Duane stays on the west coast for several tours. After being out of their Virginia Beach home for 12 years Duane and Lareese decide to sell it. The house has had some time to appreciate in value and sells for $350,000.

Tax implications:

1. Depreciation - net gain $17,455. As landlords, Duane and Lareese take a business deduction for depreciation on their house. When the house was placed in service as a rental unit their basis in it was $250,000 minus the value of the land. Only the building can be depreciated. The value of the land does not depreciate. The land was worth $90,000, so Duane and Lareese's basis in the house (for depreciation purposes) is $160,000. Residential rental properties depreciate over a period of 27.5 years. Over the 12 years it was a rental property the total depreciation was $69,818. In the 25% top marginal rate Duane and Lareese pocket $17,455 in tax savings over the 12 year period the house was rented.

2. Capital Gains Taxes - net gain $15,000. Using the 10-year suspension of the use test rules, the house still qualifies as Duane and Lareese's primary residence (they lived in it 3 of the previous 15 years). This allows up to $500,000 in capital gains to be excluded from capital gains taxes. They purchased the house and the land for $250,000 and depreciated the house by $69,818, so their basis at the time of sale was $180,182.  They sold the home for $350,000 for a gain of $169,818. The portion of gain attributable to recapturing the depreciation is NOT excludable from taxes1, but the rest of the the gain is.  Duane and Lareese would normally pay capital gains at 15%, but due to his military service they can avoid paying capital gains taxes on $100,000 of this sale. This results in a tax benefit of $15,000.

Add the depreciation and capital gains tax savings together and Duane and Lareese netted $32,445 in additional tax benefits for Duane's active duty service. That averages to over $2,700 per year they can keep in their pockets. That would have been darn good money to work into our family budget when I was on active duty. (It still would be!)

There are many additional factors when considering whether to convert your house to a rental property, but don't overlook this tremendous tax benefit available to military personnel. It might tip the scales. Everyone's specific situation is a different. If you have questions, please contact me.

1Some or all of the unrecaptured gain from the depreciation of the house while it was a rental property might be excludable from taxes, depending on your taxable income. A year you received a combat zone exclusion for your military pay might be the best year to sell to take advantage of some additional tax benefits.

 

Disclaimer

Information in the Tax Blog is current as of the day it was posted. Tax laws change frequently, and it is likely that as time passes acts of Government will make some of the older blog content out of date.

The information provided is for education purposes only. It is general in nature and may not pertain to the Reader's situation. Every taxpayer's circumstances are unique. Reader's are urged to do some research or talk to a tax professional before acting on any of the information posted in this blog.

Paul D. Allen is a proud member of the National Association of Enrolled Agents, the National Association of Tax Professionals the Financial Planning Association of Hampton Roads, the National Association of Personal Financial Advisors (NAPFA), and The Tidewater Real Estate Investors Group. You can read more about Paul's background here.

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Common Acronyms

ACTC - Additional Child Tax Credit

AGI - Adjusted Gross Income

AMT - Alternative Minimum Tax

APTC - Advanced Premium Tax Credit

AOC - American Opportunity Credit

CTC- Child Tax Credit

EIC - Earned Income Credit

HoH - Head of Household

LLC - Lifetime Learning Credit

MFJ - Married Filing Jointly

MFS - Married Filing Separately

MAGI - Modified Adjusted Gross Income

PIM - Plan of Intended Movement

PTC - Premium Tax Credit

QC - Qualifying Child

QHEE - Qualifying Higher Education Expenses

QR - Qualifying Relative

QW - Qualifying Widow(er)

 

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