Military’s Stop-the-Clock exemption, maybe you shouldn’t sell your home just yet

BLUF:  Incorporating the military stop-the-clock exemption into your planning when selling your home can save you thousands of dollars in paying unnecessary capital gains tax!

I have three Lines of Effort (LOE) in my pursuit of reaching financial independence: direct savings, equity investments, and real estate investments.  I’m obsessed about maximizing my miles and cashing in rebates because it minimizes the cost of travel that I was going to spend  anyway and hence allowing me to further support my other two efforts.  While miles are nice, all the years in obsessing about miles can be overshadowed by benefitting from tax exemptions awarded to the military.

****Before I start,  just a disclaimer that I am not a professional tax accountant by any means.  I currently don’t possess any certifications in public or tax accounting.  You should confirm if these exemptions apply specifically to your situation with your professional tax accountant before making decisions.  But a follow-up to that disclaimer is this.  I have basic reading comprehension skills… and whether its tax regulations, contracts, manufacturer’s warranties, joint pubs, or general orders; 99% of the time, basic reading comprehension and a little bit of effort is all you need to find what you are looking for.****

Many in the military are aware of the VA loan benefits when purchasing a home but less are familiar with the military’s stop-the-clock exemption to Internal Revenue Code (IRC) section 121.  I know, I know… I might have lost  half of you guys at this point, but I assure you that you want to familiarize yourself with this benefit.

Section 121 exemption can save you a significant amount of money

What is section 121?

  • It’s an exemption that allows a taxpayer to exclude up to $250,000 ($500,000 for certain taxpayers who file a joint return) of the gain from the sale (or exchange) of property owned and used as a principal residence for at least two of the five years before the sale.
  • It can be used once every 2 years.
  • Profits don’t need to go into the next resident purchase to take advantage of the exemption.

For example, Capt Snuffy, bought a house at his new duty station in 2010 for $250,000 and sold the house in 2014 for $350,000 before moving onto his next duty station.  The entire $150,000 profit is tax-free!

Now, lets say, for some reason or another, that Capt Snuffy doesn’t want to sell the house before the crucial 3 year milestone after his PCS (5 years – 2 years of residence at original duty station).  He might be a real estate guru and bought a place that is generating a net positive through rent, or he’s letting his mother live there, etc.  This is where the military stop the clock exemption comes into play.  It stops the clock if military orders moves you more that 50 miles from your home.

How do you know if you can utilize this exemption?  According to irs.org:

Service, Intelligence, and Peace Corps Personnel

If you are a member of the Uniformed Services or the Foreign Service, or an employee of the intelligence community in the Unites States, you may choose to suspend the 5-year test period for ownership and use if you are on qualified official extended duty. This means you may be able to meet the 2-year residence test even if, because of your service, you didn’t actually live in your home for at least the 2 years during the 5-year period ending on the date of sale.

You are on qualified extended duty if:

  1. You are called or ordered to active duty for an indefinite period, or for a definite period of more than 90 days.
  2. You are serving at a duty station at least 50 miles from your main home, or you are living in government quarters under government orders.
  3. You are one of the following:
    1. A member of the armed forces (Army, Navy, Air Force, Marine Corps, Coast Guard);
    2. A member of the commissioned corps of National Oceanic and Atmospheric Administration (NOAA) or the Public Health Service;
    3. A Foreign Service chief of mission, ambassador-at-large, or officer;
    4. A member of the Senior Foreign Service or the Foreign Service personnel; or
    5. An employee, enrolled volunteer, or enrolled volunteer leader of the Peace Corps serving outside the United States.

Period of suspension.

The period of suspension can’t last more than 10 years. Together, the 10-year suspension period and the 5-year test period can be as long as, but no more than, 15 years. You can’t suspend the 5-year period for more than one property at a time. You can revoke your choice to suspend the 5-year period at any time.

Here is a  scenarios directly from the irs.org website that help to wrap your head around the benefit.

Mary bought a home on May 1, 2000. She used it as her main home until August 27, 2003. On August 28, 2003, she went on qualified official extended duty with the Navy. She didn’t live in the house again before selling it on August 1, 2016. Mary chooses to use the entire 10-year suspension period. Therefore, the suspension period would extend back from August 1, 2016, to August 2, 2006, and the 5-year test period would extend back to August 2, 2001. During that period, Mary owned the house all 5 years and lived in it as her main home from August 2, 2001, until August 28, 2003, a period of more than 24 months. She meets the ownership and use tests because she owned and lived in the home for at least 2 years during this test period.

For duty stations with high property values like Hawaii or Washington D.C., it is very likely for a house to increase $200K…$300K…$400K over a 8..10..12 year period.   This exemption still applies even if you rent out the place but you would have to pay back the depreciating value you deducted while as a rental property.  Also, you can only apply this benefit to one property at any given time.

By utilizing the “stop the clock” exemption, I won’t pay any capital gains tax when I sell my house in FL after 9 years of paying down the mortgage, rental income, and appreciation!  Without this exemption, I would be paying 15% of long-term capital gains tax on the appreciation of the house!  Following the sell, I’ll apply the exemption to my house in HI.

Have you taken advantage of the stop-the-clock exemption?  What was your experience in using this exemption?