Tax Benefits for Military Personnel

By Lorraine D. Evans, MS, CPA, Senior Tax Manager, Grant Bennett Associates, Sacramento, CA, and Ellen D. Cook, MS, CPA, Professor of Accounting, University of Louisiana–Lafayette, Lafayette, LA, Members, AICPA Tax Division’s Individual Income Taxation Technical Resource Panel

A number of provisions in the Military Family Tax Relief Act of 2003 (MFTRA)¹ and the Working Families Tax Relief Act of 2004 (WFTRA)² grant tax relief to military personnel and their families. While relief from the ownership and use tests under the Sec. 121 exclusion for personal residence sale gain was the most anticipated of the MFTRA changes, taxpayers will also benefit from an increased exclusion of death benefits, favorable travel expense deductions, expansion of filing extensions and changes in the tax treatment of withdrawals under Coverdell education savings accounts (ESAs) and qualified tuition plans (QTPs). More favorable treatment of excluded combat pay when computing the child credit and the earned income credit (EIC) round out the MFTRA benefits. The provisions have varying effective dates; thus, it is essential to timely file various elections and amendments and 2004 returns.

Personal Residence Sales

Sec. 121 provides that taxpayers may exclude up to $250,000 ($500,000 for certain joint filers) of the gain on the sale or exchange of a principal residence. To qualify for the full exclusion, the taxpayer(s) must have owned and used the home as their principal residence for at least two years of the five-year period ending on the sale or exchange date. Regs. Sec. 1.121-1(c)(2)(i) suggests that short temporary absences (e.g., vacation and seasonal allowances) will not disqualify taxpayer(s) for the exclusion.

Under MFTRA Section 101(a), creating new Sec. 121(d)(9), the running of the five-year period for ownership and use may be suspended by election during any time an individual or his or her spouse is serving on qualified official extended duty as a member of the uniformed services or the Foreign Service. According to Sec. 121(d)(9)(B), the five-year period may not be extended for more than 10 years. This provision applies to sales or exchanges after May 6, 1997, under MFTRA Section 101(b)(1).

For election purposes, Sec. 121(d)(9)(C)(i) defines “qualified official extended duty” as any extended duty while serving at a duty station at least 50 miles from the residence or while residing under government orders in government quarters. Sec. 121(d)(9)(C)(iv) defines “extended duty” as any period of active duty pursuant to a call or order to such duty for a period in excess of 90 days or for an indefinite period.

Under Sec. 121(d)(9)(C)(ii), “uniformed services” are defined as in 10 USC Section 101(a)(5), and include the Armed Forces (Army, Navy, Air Force, Marine Corps and Coast Guard) and commissioned corps of the National Oceanic and Atmospheric Administration and Public Health Service. According to Sec. 121(d)(9)(C)(iii), “member of the Foreign Service of the United States” is as defined in Section 103(1)–(5) of the Foreign Service Act of 1980, as in effect on Nov. 11, 2003.

Example 1: Lieutenant B owned a house in Ohio and lived there from December 1990 until deployed overseas in January 1993. When he returned to the U.S. in July 2001, he was stationed 90 miles from his home. Preferring not to commute, he sold the house four months later for a $150,000 gain. Because B had not used the home as his principal residence during the five years preceding the sale, he reported the capital gain on his 2001 return.

After the MFTRA, B can disregard both the 812 years he was stationed overseas and the four months after his return to the U.S. and before the sale, as he was stationed more than 50 miles from his former residence. B’s five-year test period for ownership and use consists of the five years before January 1993. Because B owned and lived in the house for more than two years during the test period, he can exclude the sale gain. Assuming he filed his 2001 return before April 16, 2002, B must file an amended return by April 15, 2005, to recover the capital gain tax paid on the 2001 return.

Example 2: The facts are the same as in Example 1, except that when B returned to the U.S., his duty station was only 40 miles from the house. Thus, only the time overseas can be disregarded. B’s five-year test period for ownership and use consists of the four months in 2001 and the 56 months before January 1993 (when he went overseas). Because B lived in the house for more than two years during the test period, he may exclude the sale gain. He must file an amended return by April 15, 2005, to recover the capital gain tax paid on his 2001 return.

Example 3: Colonel W owned and lived in her Ohio house for three years before being sent overseas in January 1988. She was still overseas when she sold the house in January 2003. She may disregard only 10 of her 15 years overseas, so her five-year test period consists entirely of years in which she did not live in the house, leaving her ineligible for the exclusion.³

Example 4: Sergeant D owned and lived in a Virginia townhouse for 10 months before being deployed overseas in February 1991. She returned in 1995 and lived in the townhouse for 16 months before she was assigned to a Texas duty station in late August 1996. She married; when the couple returned to Virginia in July 1999, they bought a nearby house. They sold the townhouse in July 2001. Having lived in the townhouse only one month in the five years preceding its sale, they reported the capital gain on their 2001 return.

Post-MFTRA, they may disregard the time spent overseas and in Texas when determining the five-year test period, which would then consist of the (1) two years from July 1999 to July 2001, when they lived nearby, (2) 16 months D lived in the townhouse in 1995–1996 and (3) 10 months before the February 1991 overseas deployment. During the test period, D owned and lived in the townhouse for 26 months, so she may exclude up to $250,000 of gain on its sale. Because her husband never lived in the townhouse, he does not qualify for an exclusion. The couple has until April 15, 2005, to file an amended return claiming a refund of the capital gain tax paid on the excludible amount.

The suspension of the measurement period also applies in (1) calculating the reduced gain exclusion under Sec. 121(c)(2) for otherwise-eligible taxpayers who do not qualify for the full exclusion; and (2) determining use periods when an individual is in out-of-residence care under Sec. 121(d)(7). Specifically, a taxpayer who fails to meet the time and use restrictions, and whose primary reason for the sale or exchange is due to a “change in place of employment, health, or unforeseen circumstances,” may be entitled to a reduced exclusion under Sec. 121(c)(1)(B). Final regulations issued in August 2004⁴ provide a general definition and safe harbors for these terms.

Example 5: Lieutenant H is a U.S. Marine officer stationed in California. He purchased a house in California in 2002. In May 2003, he moved out to take a three-year assignment in Germany. He sold his house in January 2004. Because H’s new place of employment in Germany is at least 50 miles farther from the residence sold than is his former place of employment in California, the sale is within the safe harbor; he can claim a reduced maximum exclusion under Sec. 121(c)(2).

Under Sec. 121(d)(9)(D), the election is limited to one property at a time and may not be made if an election is in effect for any other property; also, the election may be revoked at any time. According to Regs. Sec. 1.121-5, the election is made by filing a return for the tax year of the sale or exchange that does not include the gain in the taxpayer’s income. No guidance is provided, however, on how to revoke the election. The logical assumption would be to file an amended return reporting the gain not previously included.

Open questions: There are numerous unresolved issues, including the following:

1. According to the regulations, the election is not made until the taxpayer files a return for the year of the sale. Thus, the determination as to whether an election is in effect with respect to another property cannot be made until then.

2. The regulations do not indicate that the return must be filed timely. This omission appears to leave the election rather open-ended and subject to the statute of limitations. For a taxpayer not otherwise required to file a return, does this mean that failing to do so constitutes not making the election?

3. If a married individual qualifies for the suspension and his or her spouse, who does not qualify, get a divorce, does the suspension end as to the individual’s former spouse at the time of the divorce?

4. Further complications may arise when trying to apply the suspension provision in conjunction with the rules on divorced spouses under Sec. 121(d)(3), involving transfers between spouses or between former spouses incident to a divorce (i.e., the period the individual owns the property includes the period the transferor owned the property). Will the suspension rules apply in these cases?

5. If one of the spouses dies, how does Sec. 121(d)(2) apply? If a married individual who qualifies for the suspension dies while on qualified official extended duty and his or her surviving spouse does not independently qualify for the suspension of the five-year period, will the suspension end as to the surviving spouse at the time of the decedent’s death?

6. State conformity or nonconformity to the rules could also be an issue.

Practically speaking, this “simple” new law triggers many unforeseen circumstances that require further guidance.

Other Tax Benefits

The MFTRA included a number of other provisions that afford tax benefits to military personnel and their families; see the exhibit for the MFTRA and WFTRA amendments.

Death gratuities: Prior to the MFTRA, Sec. 134(b) provided that qualified military benefits (defined as those received by a member or former member of the U.S. uniformed services or his or her dependent that were not taxable on Sept. 9, 1986) were excludible from income. The military death benefit or gratuity is paid to the family of military service personnel killed in a combat zone, as well as to certain members of the armed services on active duty, in inactive duty training or engaged in authorized travel. Although the death gratuity for military personnel under 10 USC Section 1478(a) had increased from $3,000 to $6,000, Congress had failed to change Sec. 134, thus making $3,000 inadvertently taxable since 1991.

MFTRA Section 102(a) increased the death gratuity to $12,000 and provided that the entire payment—including any future increases—is excluded from gross income effective for deaths occurring after Sept. 10, 2001. Thus, operations in Afghanistan, Iraq and other locations after Sept. 11, 2001 are covered by these provisions. Taxpayers who received more than $3,000 on account of an eligible death occurring after Sept. 10, 2001 may want to file amended returns.

Dependent care assistance: MFTRA Section 106 clarified that payments made to members of the Armed Forces under dependent care assistance programs are deemed qualified military benefits under Sec. 134 and excluded from gross income, effective for tax years beginning after 2002. The exclusion is available to all members of the uniformed services (including those listed in the Sec. 121 discussion above).

Travel expenses: Under MFTRA Section 109(b), Sec. 62(a)(2) was amended to provide an above-the-line deduction for unreimbursed travel expenses of National Guard troops and reservists, when such travel takes the taxpayer more than 100 miles away from home and requires an overnight stay. Under MFTRA Section 109(c), the change applies to expenses paid or incurred after 2002.

Extensions: MFTRA Section 104 amended the Sec. 7508 extensions that apply to a variety of tax-related activities (including return filing and paying available to military personnel in a Presidentially declared combat zone), to include military personnel assigned to contingency operations designated by the Secretary of Defense. A “contingency operation,” as defined in 10 USC Section 101(a)(13), is a military operation in which members of the Armed Forces are, or may become, involved in military actions or hostilities against an enemy of the U.S. Also included are calls to service during a national emergency declared by the President or Congress.

The extended deadlines apply as well to individuals in support and humanitarian activities in combat zones, including members of the Merchant Marine, Red Cross personnel, accredited correspondents and civilian personnel engaged in support activities. Under Sec. 7508(c), spouses of qualifying individuals are entitled to the same suspension of time, except that a spouse is ineligible for suspension for any tax year beginning more than two years after the date of termination of combatant activities in the combat zone.

According to Sec. 7508(a) and (g), the suspension encompasses the period of service in the specified area, as well as any time of continuous qualified hospitalization resulting from injury received in the zone or time in missing-in-action status, plus the next 180 days. Items qualifying under Sec. 7508(a)(1) for extension include the filing of any income, estate or gift tax return; payment of any income, estate or gift tax; filing of Tax Court petitions; allowance of a credit or refund; filing a claim for credit or refund; bringing suit on any claim for credit or refund; assessment of any tax; collection of any liability; and bringing suit by the U.S. for liability for any tax. The suspension applies to any period for performing an act that did not expire before the date of the MFTRA’s enactment (Nov. 11, 2003).

HAP exclusion: The Department of Defense’s Homeowners Assistance Program (HAP) provides payments to Armed Forces members whose housing values have decreased due to military base realignment or closure. Pre-MFTRA, such payments were deemed compensation for services and, thus, includible in income and subject to FICA to the extent they exceeded the fair market value (FMV) of the property relinquished for such payments. MFTRA Section 103 expanded Sec. 132 to allow for the exclusion from gross income and FICA wages of amounts received under the HAP, up to the reduction in the property’s FMV. According to MFTRA Section 103(c), the provision is effective for payments made after the enactment date.

Coverdell ESAs and QTPs: Generally, withdrawals from Sec. 530 Coverdell ESAs and Sec. 529 QTPs are excluded from gross income to the extent they paid for qualified educational expenses. Withdrawals not so excluded are included in income and subject to a 10% early withdrawal penalty. An exception exists for withdrawals or distributions stemming from the beneficiary’s death, disability or receipt of a scholarship. Because appointments to the U.S. Military, Navy, Air Force, Coast Guard and Merchant Marine Academies require a future military commitment, they are not scholarships; thus, withdrawals from ESAs and QTPs for appointed beneficiaries are both taxable and subject to penalty.

MFTRA Section 107(a) amended these provisions, to treat a service academy appointment as a scholarship to the extent of the cost of the advanced education; the penalty is waived. According to MFTRA Section 107(b), this provision is effective for tax years beginning after 2002.

WFTRA Provisions

WFTRA Section 104(a) amended Sec. 24(d)(1) to provide that combat pay otherwise excluded from gross income by Sec. 112 is treated as earned (and, thus, taxable) income for purposes of calculating the refundable portion of the child credit. The same is true for the computation of the Sec. 32 EIC, under WFTRA Section 104(b). These provisions effectively increase both credits. According to WFTRA Section 104(c), the child credit provision is available for tax years beginning after 2003. Under WFTRA Section 104(b), the EIC election applies to tax years ending after the enactment date (Oct. 4, 2004) and before 2006.

Rev. Proc. 2004-26

The IRS issued Rev. Proc. 2004-26⁵ to provide guidance for representatives (1) of certain U.S. military or civilian employees who die from injuries sustained in terrorist or military action and (2) seeking forgiveness of tax liability under Sec. 692(c). Such forgiveness applies to the tax year of death and for any earlier tax year beginning with the year before the one in which the wounds or injury occurred.

Conclusion

Further activity in the area of military personnel taxation is expected. Versions of the Guardsmen and Reservists Financial Relief Act of 2004⁶ have passed both the House and Senate. The bill amends Sec. 72(t) to exempt from the 10% penalty on early distributions from tax-exempt retirement plans, withdrawals made by military reservists or National Guard members called to active duty for six months or more. It also permits reimbursement of such withdrawals within two years after the end of the active duty period.

The bill, as passed, is effective for individuals ordered or called to activity duty after Sept. 11, 2001 and before Sept. 12, 2005, for retirement plan distributions after Sept. 11, 2001. With this and other bills still on the horizon, members of the military, their families and tax advisers should continue to monitor Congressional activity.