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IRS.gov Website
Publication 3
taxmap/pubs/p3-002.htm#en_us_publink1000176201

Combat Zone Exclusion(p8)

rule
If you are a member of the U.S. Armed Forces who serves in a combat zone (defined later), you can exclude certain pay from your income. This pay is generally referred to as "combat pay." You do not actually need to show the exclusion on your tax return because income that qualifies for the combat zone exclusion is not included in the wages reported on your Form W-2. (See Form W-2, later.)
The month for which you receive the pay must be a month in which you either served in a combat zone or were hospitalized as a result of wounds, disease, or injury incurred while serving in the combat zone. You do not have to receive the excluded pay while you are in a combat zone, are hospitalized, or in the same year you served in a combat zone.
If you are an enlisted member, warrant officer, or commissioned warrant officer, you can exclude the following amounts from your income. (Other officer personnel are discussed under Amount of Exclusion, later.)
Retirement pay and pensions do not qualify for the combat zone exclusion.
taxmap/pubs/p3-002.htm#en_us_publink1000176205

Partial (month) service.(p9)

rule
If you serve in a combat zone for any part of one or more days during a particular month, you are entitled to an exclusion for that entire month.
taxmap/pubs/p3-002.htm#en_us_publink1000176206

Form W-2.(p9)

rule
The wages shown in box 1 of your 2012 Form W-2 should not include military pay excluded from your income under the combat zone exclusion provisions. If it does, you will need to get a corrected Form W-2 from your finance office.
You cannot exclude as combat pay any wages shown in box 1 of Form W-2.
taxmap/pubs/p3-002.htm#en_us_publink1000176207

Combat Zone(p9)

rule
A combat zone is any area the President of the United States designates by Executive Order as an area in which the U.S. Armed Forces are engaging or have engaged in combat. An area usually becomes a combat zone and ceases to be a combat zone on the dates the President designates by Executive Order.
taxmap/pubs/p3-002.htm#en_us_publink1000176208

Afghanistan area.(p9)

rule
By Executive Order No. 13239, Afghanistan (and airspace above) was designated as a combat zone beginning September 19, 2001. On December 14, 2001, the following countries were certified by the Department of Defense for combat zone tax benefits due to their direct support of military operations in the Afghanistan combat zone.
Note. For the Philippines only, the personnel must be deployed in conjunction with Operation Enduring Freedom supporting military operations in the Afghanistan combat zone.
taxmap/pubs/p3-002.htm#en_us_publink1000176209

The Kosovo area.(p9)

rule
By Executive Order No. 13119, the following locations (including airspace above) were designated as a combat zone beginning March 24, 1999. Note. The combat zone designation for Montenegro and Kosovo (previously a province within Serbia) under Executive Order 13119 remains in force even though Montenegro and Kosovo became independent nations since EO 13119 was signed.
taxmap/pubs/p3-002.htm#en_us_publink1000176210

Arabian peninsula.(p9)

rule
By Executive Order No. 12744, the following locations (and airspace above) were designated as a combat zone beginning January 17, 1991.
taxmap/pubs/p3-002.htm#en_us_publink1000176211

Serving in a Combat Zone(p10)

rule
You are considered to be serving in a combat zone if you are either assigned on official temporary duty to a combat zone or you qualify for hostile fire/imminent danger pay while in a combat zone.
Service in a combat zone includes any periods you are absent from duty because of sickness, wounds, or leave. If, as a result of serving in a combat zone, a person becomes a prisoner of war or is missing in action, that person is considered to be serving in the combat zone so long as he or she keeps that status for military pay purposes.
taxmap/pubs/p3-002.htm#en_us_publink1000176212

Hospitalized While Serving in a
Combat Zone(p10)

rule
If you are hospitalized while serving in a combat zone, the wound, disease, or injury causing the hospitalization will be presumed to have been incurred while serving in the combat zone unless there is clear evidence to the contrary.
taxmap/pubs/p3-002.htm#en_us_publink1000176213

Example.(p10)

You are hospitalized for a specific disease in a combat zone where you have been serving for 3 weeks, and the disease for which you are hospitalized has an incubation period of 2 to 4 weeks. The disease is presumed to have been incurred while you were serving in the combat zone. On the other hand, if the incubation period of the disease is 1 year, the disease would not have been incurred while you were serving in the combat zone.
taxmap/pubs/p3-002.htm#en_us_publink1000176214

Hospitalized After Leaving a Combat Zone(p10)

rule
In some cases, the wound, disease, or injury may have been incurred while you were serving in the combat zone, even though you were not hospitalized until after you left. In that case, you can exclude military pay earned while you are hospitalized as a result of the wound, disease, or injury.
taxmap/pubs/p3-002.htm#en_us_publink1000176215

Example.(p10)

You were hospitalized for a specific disease 3 weeks after you left the combat zone. The incubation period of the disease is from 2 to 4 weeks. The disease is presumed to have been incurred while serving in the combat zone.
taxmap/pubs/p3-002.htm#en_us_publink1000176216

Nonqualifying Presence in Combat Zone(p10)

rule
None of the following types of military service qualify as service in a combat zone.
taxmap/pubs/p3-002.htm#en_us_publink1000176217

Service Outside Combat Zone Considered Service in Combat Zone(p10)

rule
Military service outside a combat zone is considered to be performed in a combat zone if:
Military pay received for this service will qualify for the combat zone exclusion if all of the requirements (other than service in a combat zone) are met and the pay is verifiable by reference to military pay records.
taxmap/pubs/p3-002.htm#en_us_publink1000176218

Amount of Exclusion(p10)

rule
If you are an enlisted member, warrant officer, or commissioned warrant officer and you serve in a combat zone during any part of a month, you can exclude all of your military pay for that month. It should not be included in the wages reported on your Form W-2. You also can exclude military pay earned while you are hospitalized as a result of wounds, disease, or injury incurred in the combat zone. If you are hospitalized, you cannot exclude any military pay received for any month of service that begins more than 2 years after the end of combat activities in the combat zone. Your hospitalization does not have to be in the combat zone.
If you are a commissioned officer (other than a commissioned warrant officer), you can exclude your pay according to the rules just discussed. However, the amount of your exclusion is limited to the highest rate of enlisted pay (plus imminent danger/hostile fire pay you received) for each month during any part of which you served in a combat zone or were hospitalized as a result of your service there.