There’s no secret that military members go through a permanent change of station (PCS) move every 2-3 years. It’s also not a secret that many service members become landlords and have successful real estate investment strategies. Coincidence? I think not! I’m going to explain, in my opinion how / why the military can leverage their frequent moves and “service member” status to shield capital gains, reduce expenses, and start and high-cashflow portfolio of properties.
Military Moves Are Awesome!
Finding a new house, dentist, vet, and schools for kids every two years may not sound like a party during a PCS. However, the move itself can be a strategic, financial weapon in your Financial Independence / Retire Early (FIRE!) arsenal. Typically, capital gains are either taxed at the short-term (< 1 year hold) or long-term (> 1 year hold) capital gains tax rates; short-term gains are taxed are your ordinary income rate and long-term gains are taxed are either 0% / 15% / 20%, depending on income level. However, a military permanent change of station move will shield any capital gain from taxes on your primary residence up to $250,000 or $500,000 if married and filing jointly on your tax return; the requirement is to live in your primary residence for 2 of the past 5 years to be eligible for the tax exemption; because military assignments will last 2-3 years, most moves should qualify. Even if you convert your primary residence to a rental property for 3 years or less after moving (still meeting the 2 of the past 5 year primary residence requirement), you will still avoid capital gains tax when selling. Convert your primary residence to a rental property, cashflow, let it appreciate while tenants pay your mortgage, and sell without paying capital gains tax! Note: when converting to a rental property, you will still be taxed on depreciation recapture when selling – different than capital gains tax (see your CPA).
BUT here comes the military strategy! Even if the assignment is less than 2 years, you will still be eligible for the capital gains tax exemption when selling. Because the PCS was required by the DOD (and usually > 50 miles from current residence), you will be eligible for a prorated capital gains tax shield based on the length of time (in months) you resided in the primary residence; i.e. residing in Texas for a year prior to a PCS to Arizona will shield up to $125,000 (single) / $250,000 (filing jointly) – [12mo/24mo] x $250,000/$500,000].
Veteran’s Affair (VA) Loan Strategy
Veteran’s Affair loans are backed by the VA, but can only be used for primary residences that will be occupied by the service member / family. They have a variable, but low, VA funding fee and are eligible for up to 100% financing; the loan to value ratio (LTV) will drive the VA funding fee. Putting more money down (even 5%) will reduce your VA funding fee, as the additional equity reduces the loan’s risk to the VA. VA loans will also have a lower interest rate than fixed-rate, 30 year mortgage loans; Federally Housing Authority (FHA) loans; and investment loans. Loans specifically for investment properties are considered “investment” loans. Because they carry a higher level of risk to the ultimate holder of the loan (Fannie Mae / Freddie Mac), that risk is priced into the interest rate you’ll pay on the loan. When shopping for a mortgage on an investment property, you typically get an interest rate 1% – 1.5% higher than the interest rate on a fixed-rate, 30 year primary residence mortgage (and even higher when compared to a VA loan). Additionally, you’ll likely need to put 10% to 20% down on an investment property loan. So, strictly dealing with building an investment property portfolio, you’ll have higher interest rates and a higher down payment, which will reduce your ROI, increase your monthly expenses, and reduce your ability to cashflow.
BUT here comes the military strategy! VA loans can be used to fund the purchase of your primary residence during each PCS, which can be secured at a low, fix-rate for 30 years during the life of the loan. Leveraging this low interest rate and low down payment when you move is a critical enabler to increasing your ROI, reducing monthly expenses, and increasing your ability to cashflow when converting the primary residence to an investment property. While the primary intent and initial use of the property must be as a primary residence, once you have occupied, resided in, and moved from the property, its use can be converted to an investment property while still being backed by the low-rate, VA loan. Importantly, the VA will verify (and should) that the property’s initial intended use will be as a primary residence. Trying to use a VA loan for any other purpose is illegal and constitutes mortgage fraud. However, if used correctly, the VA loan process, initial property use as a primary residence, and conversion to investment property can be repeated at every duty station up to the total VA loan limit of $548,250 for 2021 (higher in more expensive housing markets).