Military families have special tax breaks — but the rules can be tricky, experts say

• Many members of the U.S. armed forces qualify for special tax breaks that aren't available to other Americans.
• Some of the key benefits include state residency flexibility, tax-exempt allowances, combat pay and more.

Many members of the U.S. armed forces qualify for special tax breaks that aren't available to other Americans.

While eligibility can be complicated, these benefits offer unique tax planning opportunities, experts say.

As a military spouse and certified financial planner, Collin Lyon, wealth strategy advisor at Anderson Financial Strategies in Dayton, Ohio, has explored these tax breaks with hundreds of clients.

"A lot of them know parts of their income aren't taxable," he said. "But they're not really sure what parts those are."

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Here are some of the key tax breaks that military families need to know about, according to financial advisors.

Keep your state residency

Members of the military often move frequently, but many families save on state taxes via a special federal law, experts say.

Under the Servicemembers Civil Relief Act, state income tax is based on your "state of legal residence" during active duty, regardless of where you're stationed. If eligible, it's possible to keep that residency through your military career.

"Military members tend to have residency in states without an income tax," such as Florida, Texas or Washington, said CFP Curtis Sheldon, who is also an enrolled agent at C.L. Sheldon and Company in Alexandria, Va. The firm specializes in working with active and retired military members. 

Tax-exempt 'allowances'

Another unique benefit for service members is tax-exempt "allowances," Sheldon said.

Generally, pay is taxable, whereas most allowances — such as funds for housing and food — are tax-exempt, he explained.

"They don't get reported anywhere on the tax return," and these items don't show up on Form W-2, he said. "It's something you have to keep track of yourself."

Combat zone income tax exclusion

If you serve in a combat zone, your income from those months is also excluded from taxation, and even a single day counts for a full month exclusion, experts say.

Excluded income could include basic pay, bonuses, student loan repayments and more, according to the IRS.

However, your "hazard duty pay" can still count as earnings to make Roth individual retirement account contributions or qualify for earned income tax credit eligibility, Lyon said.       

'Stop the clock' on home capital gains

When selling a primary residence, many homeowners can exclude a portion of profits from capital gains taxes. 

Generally, the limit is $250,000 for single filers or $500,000 for married couples filing jointly. But you must meet the "use test" by living in the home for two of the last five years before the sale.

That rule is suspended for members of the armed forces, Sheldon said: "You get to stop the clock."

That means it's still possible to qualify for the tax break, even without meeting the two-year use test, if you lived elsewhere while on "qualified official extended duty," according to the IRS. 

However, the suspension of the five-year period is limited to 10 years, according to the IRS.

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