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Retired Military Finances 301: Non-Qualified Use of Real Estate Thumbnail

Retired Military Finances 301: Non-Qualified Use of Real Estate

Retirement Funding Taxes

I spend a little time on Facebook. One of the things I do is join groups related to military finances to see what is on people's minds. I was reading on the other day and a guy who is pretty savvy mentioned that he knew retired military members that were moving around the country to move back into their houses for 2 years to qualify for the Primary Residence Exclusion (more correctly the Section 121 exclusion) in order to shield their gains from taxation. There is just one problem. The Tax Code doesn't work that way. To prevent this exact scenario from happening, the Congress wrote into law the concept of non-qualified use.

What is the 121 Exclusion?

Section 121 of the Tax Code basically states that if you live in a home for 2 of the last 5 years, any gains on it, subject to limitations, are excluded from income and therefore not taxable. The basic limit is $250,000 for single taxpayers and $500,000 for married taxpayers. There are some other qualifying factors and if you want to you can learn more about them at here.

There is a specific carve-out for Active-Duty Military Members that allows you to suspend the clock for up to 10 years if you move out of the house due to military orders (there are a few more requirements you can read about here) making it effectively a 2 out of 15 years (again subject to limitation).

If you don't meet the 2 out of 5 criteria with or without the special treatment for military members, all of your gains will be subject to taxation. So, many people try moving back into the property to get meet the 2-year resident requirement. Enter non-qualified use.

What is Non-Qualified Use?

In general, non-qualified use is any period of the ownership and use test that is after the last date the taxpayer or spouse used the home as a principal residence. Looking at this explanation, it would appear that any time while the house is rented would count as non-qualified use. But the code goes on to say that the any portion of the 5-year ownership test that is after the last day the taxpayer or spouse used the home as a principal residence. Said another way, if you live in it for 2 years and move out and sell it at 5 years (without moving back in), you do not have non-qualified use. What happens if you move back in? Let's look at an example.

  • You purchase a house and live in it for 2 years
  • You move out of the house and rent it for 6 years
  • You move back into the house and live in it for 2 years (and expect to qualify for the 121 exclusion)
  • The 6 years the house was rented is classified as non-qualified use
  • 60% of any gains you make will be subject to taxation as long-term capital gains (depreciation recapture is ignored in this example)

Is There Any Help for Military Members in Regard to Non-Qualified Use?

Much like the suspension of time for the 2 out of 5 rule to qualify for the exclusion, there is a special carve-out for military members. Any period, not to exceed 10 years (aggregate), that you are a member of the military and serve at least 50 miles from the primary residence or live in government quarters (under government orders) is not considered non-qualified use. This raises a couple of issues that are not crystal clear in the underlying law.

  1. If you retire from the military, the exception will no longer apply (in our opinion) as you are no longer a member of the military. If you move back into the property, you will trigger non-qualified use for any time after your retirement that you didn't occupy the property (again in our opinion)
  2. If you PCS back to the same location and move back into the property, you will not trigger non-qualified use as long as you've been gone less than 10 years. It is our opinion though, that the suspension for the 2 out of 5 rule will end and if you don't move back into the house you'll need to sell the property before you exceed the 5-year limit, or you will lose the 121 exclusion.

Military Finances are Different

As you can see, as an Active or Retired Senior Military Officer or NCO, the tax code treats you differently than your civilian counterpart. That is the case with a lot of issues pertaining to your finances. That is why we think you should work with a financial planner or advisor that deals with your unique military financial issues each and every day. If you'd like to find out how we work with people like you, use the button below to schedule a free initial consultation.

If you found this article useful, you might like the following blog posts:

So, You Want to Be a Military Landlord


Military Finances 301: Should You Buy a College Condo?


Military Landlord? You Have Estate Planning Issues


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