Congress and the White House may be poised to send hundreds of thousands of men and women in the armed forces to war in the Middle East. But neither branch of the federal government has managed to rectify the most glaring tax code inequity affecting homeowning members of the military: When service personnel are out of the country or away from their homes for extended periods, they frequently face capital gains burdens that most civilians do not.
Under the current tax code, members of the armed forces who are transferred overseas or to domestic military installations cannot count the home they own as their "principal residence" because they are no longer "using" or occupying it.
Yet to qualify for the maximum $250,000 (single-filing home sellers) or $500,000 (married joint-filing sellers) capital gains exclusions on home-sale profits, taxpayers must own and use a house as their principal residence for an aggregate two of the five years preceding the sale.
When a homeowning member of the armed forces is sent on multi-year assignments abroad, that time away can prove costly. Take this example: Say you are a career member of the military, and for years you've owned a home near your base in the United States. Then you're sent overseas on multiple assignments for five years. While you're away, you rent out the house to another family from your base.
When you and your spouse come home, you decide to sell the rental house and buy a bigger place. Thanks to the housing boom over the decade of your ownership, your property has jumped sharply in value, giving you $400,000 in potential resale profits.
But there's a hitch: You don't qualify for the $500,000 capital gains exclusion because the house has been rented out for five years. You've owned it, but not used it as your principal residence. The reason, of course, is that your government required you to be overseas, rather than at home using the house. But now the same government will levy taxes on your resale profits -- something most American home sellers avoid.
Peter Scott, a Virginia-based tax lawyer and veteran who has lobbied Congress on capital gains inequities, says this situation is an outgrowth of the 1997 rewriting of the home sale rules. Though Congress sought to simplify and improve the tax treatment of home sale gains, it inadvertently did the reverse for armed forces personnel.
"They made things worse instead of better," Scott said. Under the rules that were scrapped in 1997, the family in the example above at least could have "rolled over" their gains tax-free into their new, higher-cost home. Under regulations issued by the IRS last month, the returning members of the military would owe tens of thousands of dollars to the Treasury if they sold.
"There is no evidence in the record that Congress meant to do this," Scott said. "It was an accident, an oversight."
The same oversight creates tax liability problems for members of the diplomatic corps, noted Scott, as well as for the "hundreds of thousands" of corporate employees who go overseas on extended assignments.
Congress has made several attempts since 1997 to correct the problem for military and Foreign Service personnel, most recently last fall, when separate "tax fairness" bills passed in the House and Senate but never emerged from the lame-duck session in November.
The remedy in both houses was to treat periods of "qualified extended duty" as "suspended" from the usual two-years-out-of-five computations for ownership and use. In effect, if military or Foreign Service personnel were transferred from their homes for five years, their period of required ownership and use for capital gains purposes would be extended by five years. That would allow them to qualify for maximum capital gains exclusions if they owned and used their house as a principal residence for two out of the previous seven years.
New attempts to pass the bills are expected this year. But Scott predicted that the lost-revenue issue will be lurking in the background. "Congress discovers it's made a mistake, but then it's got to come up with the money to fix the problem." In the case of military and diplomatic personnel alone, the estimated cost to the Treasury would be $207 million over 10 years.
Scott, who serves as tax counsel to the Employee Relocation Council, a Washington-based trade group representing large employers, said a strong case can be made for including private corporate transferees in any legislation intended to fix the tax inequity for military and foreign service personnel.
The outlook for action? More in the weeks to come.
Kenneth R. Harney's e-mail address is firstname.lastname@example.org.