Income Exclusions for Members of the U.S. Armed Forces

Members of the U.S. Armed Forces are eligible for income exclusions to help increase their take-home pay. Understanding these income exclusions is essential for tax preparers assisting clients in the military so you can better advise them.

Combat Pay Income Exclusion

For members of the U.S. Armed Forces serving in combat zones, the monthly compensation they earn while serving in the combat zone is exempt from federal income tax. However, combat pay remains subject to Social Security and Medicare taxes. Any part of a day spent serving in a combat zone is considered a full month for excluding the income.

How to Qualify for the Exclusion

Service in a combat zone is when a member is either assigned on official temporary duty to a combat zone or qualifies for hostile fire or imminent danger pay while in a combat zone. Periods when the member is absent from duty because of sickness, wounds, or leave still qualify for the exclusion. Hospitalization, even after the member leaves the combat zone, may still qualify for the exclusion if the wound or injury resulted from serving in the combat zone. If a service member becomes a prisoner of war or goes missing in action due to serving in a combat zone, they are considered to serve in that combat zone if they retain that status for military pay purposes.

Additionally, services outside of a combat zone can still be considered in a combat zone and eligible for the exclusion if the member meets all the requirements for service eligible in a combat zone and:

• The Department of Defense designates that the service is in direct support of military operations in the combat zone and
• The service qualifies you for special military pay for duty subject to hostile fire or imminent danger.

What Income is Eligible for the Exclusion

Income eligible for the exclusion includes all the following types of military compensation as long as the service member’s entitlement to the compensation fully accrued during the month serving in the combat zone:

• Basic pay
• Reenlistment or Continuation Bonuses
• School Loan Repayments
• Imminent Danger/Hostile Fire Pay
• Leave Benefits
• Awards and Other Financial Incentives

Enlisted members, warrant officers, and commissioned warrant officers can exclude all the above military pay while serving in a combat zone. However, commissioned officers can only exclude the highest rate of enlisted pay in addition to imminent danger/hostile fire pay. The limit for 2023 is $10,011 per month, which consists of $9,786 for the highest enlisted pay and $225 for imminent danger pay.

Income excluded from hospitalization after serving in a combat zone is limited to two years from the last month of presence in the combat zone.

What is Considered a Combat Zone

A combat zone is an area designated by the President of the United States through an executive order as a region in which the U.S. Armed Forces are engaging or have engaged in combat. Current combat zones include the Afghanistan Area, the Kosovo Area, and the Arabian Peninsula. Congress has also designated the Sinai Peninsula of Egypt as a combat zone eligible for tax benefits under certain circumstances. To review the list of current combat zones, use this page on the IRS website.

How is Combat Pay Reported

The military organization certifies that the member is eligible for the exclusion and reduces the reportable income on their Form W-2 for the year. If members believe their box 1 wages incorrectly include excludable combat pay, they should request a corrected Form W-2.

Armed Forces members claiming the Earned Income Credit on their return may elect to include their combat pay in earned income for the credit. Those making the election must include all their nontaxable combat zone pay received. Spouses filing a joint return who are both members of the armed forces with combat pay can each make their own election without impacting the other spouse’s decision to make the election. Before making an election, tax preparers should optimize the options as the EIC depends on different factors, including earned income, filing status, and qualifying children.

Other Income Items Excluded from Gross Pay

In addition to combat pay, Armed Forces members may receive additional amounts that are excludable from gross pay, including family allowances, living allowances, moving allowances, etc. Review Publication 3, Armed Forces Tax Guide, for income items excluded from gross pay. Like combat pay, the servicemember’s box 1 wages on their Form W-2 won’t include excludable amounts. Additionally, suppose the service member uses excludable income such as their Basic Allowance for Housing to pay their mortgage or real estate taxes. In that case, they can still deduct these amounts on their Schedule A, Itemized Deductions.

Excluding Gain on Sale of Home

The standard rules for eligibility to exclude the gain on the sale of a home apply for service members – taxpayers must own their home and use it as their main home for two out of the last five years. However, an election is available for service members to help them meet the tests, even if they in fact do not. A service member can choose to suspend the five-year test period for both the use and ownership test during any period they or their spouse serves on qualified official extended duty.

For example, a service member purchases their home in September 2016 and lives there until December 2018, when they leave on extended duty. They then decide to sell the house for a gain in March 2024. The service member can elect to suspend the five-year test from December 2018 to March 2024 while serving on qualified official extended duty. Accordingly, the five-year test applies to the period before the member leaves in December 2018, and they are eligible to exclude the gain from the sale subject to the applicable limits.

Closing Thoughts

The tax exclusions mentioned above are only some of the tax benefits offered to service members. Understanding these income exclusions is essential for advising clients serving in the U.S. Armed Forces.

By Ashley Akin, CPA

Sources

• Armed Forces’ Tax Guide: For use in preparing 2023 returns (irs.gov)
• Tax Exclusion for Combat Service  (irs.gov)

Stay up-to-date!

SIGN UP FOR EMAIL NOTIFICATIONS