With the war in Iraq winding down, Congress finally passed long-awaited reforms to the home-sale capital gains rules affecting members of the U.S. military and Foreign Service before adjourning for the Easter/Passover recess. The changes to the tax code are expected to save thousands of home-owning members of the military millions of dollars per year in home sale taxes.

Separate versions of the Armed Forces Tax Fairness Act passed the House and Senate, after more than two years of delays and failed attempts. Differences between the two bills were mainly--but not completely--resolved before adjournment last week. Once the Senate approves a final version of the bill, it will go to the President for signing and take effect immediately.

The legislation remedies one of the most glaring inequities in the U.S. tax code: higher tax burdens for homeowning military and Foreign Service personnel who are assigned overseas for exended periods. Under capital gains tax rules adopted in 1997, all home sellers can pocket tax-free up to $250,000 (single filers) or up to $500,000 (married joint filers) of their home sale profits, provided they have owned and occupied their home as a “principal residence” for two of the five years preceding the sale.

Many members of the military or Foreign Service have difficulty meeting the strictly-enforced two-out-of-five-years rule, and end up paying capital gains taxes on their sales. This is because many of them serve overseas on extended, multi-year assignments, then come home for short periods before being reassigned to another location far away from their homes. In the case of members of the military, the assignments may be to bases located in the continental U.S., but they still require them to be absent from their properties. Many of service families rent out their homes while they are away--turning the properties into investment-category assets ineligible for residential capital gains breaks.

The net effect is that military and Foreign Service homeowners frequently are not able to accumulate two years worth of qualifying time occupying their homes as principal residences. Under the new legislation, their overseas or domestic assignments will be “suspended” from being counted against the two-out-of-five year clock. For example, if you are in the military and you own and occupy your house for a few years before being sent on multiple assignments overseas totalling five years, you’ll now be able to suspend those five years and count the three to qualify under the capital gains rules.

The House version requires military personnel to be on “qualified official extended duty” to receive the suspension. That means a minimum of 180 days at a “duty station” located at least 150 miles from the service members home or when residing under government orders in government quarters.

The amendments to the capital gains rules should cover tens of thousands of homeowning military and State Department families, according to Capitol Hill tax experts, and will be retroactive to 1997.

Published: April 21, 2003

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consmer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.