Military Finances 401: When 1031 + 121 = $0

It is pretty common for a military family to PCS and turn their primary residence into a rental. When we talk to someone about doing that, we make sure they understand the tax scenario they're walking into. So, what does that mean?

Meet Depreciation

When you rent a house, you're required to depreciate it. In essence, depreciation is accounting for the structure wearing out (you don't depreciate land). When you sell the property and it didn't, in fact, wear out you'll be taxed on the depreciation you claimed. It's commonly called depreciation recapture. That can make the potential rental a little less inviting (in case you're thinking about skipping depreciation, you can't. That's considered an unauthorized accounting system by the IRS).

Avoiding Depreciation Recapture

One way to avoid (or delay) depreciation recapture is to execute a 1031 exchange. In a 1031 exchange, you go through a somewhat complicated chain of events when you sell your rental property and buy a replacement rental property. If you satisfy the requirements, the exchange is tax deferred.

What About the Primary Residence Exclusion?

Under the basic rule, if you live in a house for 2 out of 5 years, you can exclude up to $500,000 of gains from taxation ($250,000 if not married filing jointly). This called the 121 exclusion. For Active Duty members, you can extend the five-year limit for up 10 years if your move is due to a PCS (or you're required to move into base housing). In essence, the clock stops for up to 10 years making the rule 2 out of up to 15 years.

Pick Your Poison

If you do rent the house out for a significant amount of time, the house could appreciate quite a bit. Now you think you have the choose. Do you sell the house outright to take advantage of the exclusion, or do you do a 1031 exchange to defer taxes on the depreciation recapture? It is a tough decision. What if you didn't have to make a decision?

1031 + 121 = $0

If you have been renting your prior primary residence and you meet the 2 out of 5 (up to 15 if Active Duty), you can combine the rules for the primary residence exclusion and depreciation recapture. This can allow you to take advantage of the primary residence exclusion of up to $500,000 ($250,000 if not MFJ), put some cash in your pocket and avoid taxes on it. You then do a 1031 exchange for the remainder and defer taxes on depreciation recapture. Here is an example.

You PCS to Base X and buy a house at timeline 0, for $750,000
You live in the house for 3 years and turn it into a rental when you PCS
You rent it for 5 years and take about $20,000 in depreciation each of the 5 years
As the end of year 8 approaches your house has appreciated to $1,000,000. You've also booked $100,000 in depreciation.
You decide to sell the house.
When you sell the house, you can exclude $250,000 from income under the 121 exclusion and not pay tax on any of it.
You also decide to do a 1031 exchange and buy a replacement property for at least $750,000 (in essence) and don't receive any economic benefit from the sale (you don't get any cash, and your loan amount doesn't go down any). The tax on the depreciation is deferred until such time as you sell the replacement property, or you die and receive a step-up in basis.

This is all a little complicated and you definitely have to meet all the requirements, but you can save some real money on taxes.

Military Finances are Different

Like we saw in this article, military members and retirees receive special tax treatment. There are other differences in your financial life as well. That's why we think Active Duty and Retired Senior Military Officers and NCOs should work with a financial planner or advisor that has those differences down cold. If you'd like to find out how we work with clients just like you, use the button below to schedule a free, initial consultation.

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