The Foreign Service Journal, January-February 2014

66 JANUARY-FEBRUARY 2014 | THE FOREIGN SERVICE JOURNAL AFSA NEWS 2013 AFSA TAX GUIDE improvements, in which case the $1 million limit applies. The $100,000 ceiling applies to the total of all home equity loans you may have. The same generally applies to refinancing a mort- gage. Points paid to obtain a refinanced loan cannot be fully deducted the same year, but must be deducted over the life of the loan. It is advisable to save the settle- ment sheet (HUD-1 Form) for documentation in the event your tax return is selected by the IRS for audit. Qualified residences are defined as the taxpayer’s principal residence and one other residence. The second home can be a house, condo, co-op, mobile home or boat, as long as the structure includes basic living accom- modations, including sleep- ing, bathroom and cooking facilities. If the second home is a vacation property that you rent out for fewer than 15 days during the year, the income need not be reported. Rental expenses cannot be claimed either, but all property taxes and mortgage interest may be deducted. Rental of Home Taxpayers who rented out their homes in 2013 can continue to deduct mort- gage interest as a rental expense. Also deductible are property management fees, condo fees, deprecia- tion costs, taxes and all other rental expenses. Losses up to $25,000 may be off- set against other income, as long as the Modified Adjusted Gross Income does not exceed $100,000 to $150,000 and the taxpayer is actively managing the property. Note that a taxpayer who retains a property manager does not lose this benefit, as this is still considered active management of the property. All passive losses that cannot be deducted currently are carried forward and deducted in the year the property is sold. Sale of a Principal Residence Current tax laws allow an exclusion of up to $500,000 for couples filing jointly and up to $250,000 for single taxpayers on the long-term gain from the sale of their principal residence. One need not purchase another resi- dence to claim this exclusion. All depreciation taken after May 7, 1997, will, however, be recaptured (added to income) at the time of sale and taxed at 25 percent. Since January 2009 gain from the sale of a home can no longer be excluded from gross income for periods when it was rented out before you occupied it as a principal residence for the first time. The only qualification for the capital-gains exclusion is that the house sold must have been owned and occupied by the taxpayer as his or her principal residence for at least two of the last five years prior to the date of the sale. As a result of the Military Families Relief Act of 2003, the five-year period may be extended for members of the Foreign Service by the five-year period may be extended by any period dur- ing which the taxpayer has been away from the area on a Foreign Service assignment, up to a maximum of 15 years (including the five years). There are some exceptions to the two-year occupancy requirement, including a sale due to a “change in place of employment” (this would include foreign transfers). This exclusion is not limited to a once-in-a-lifetime sale, but may be taken once every two years. When a principal resi- dence is sold, capital gains realized above the exclusion amounts are subject to taxa- tion. This exclusion replaces the earlier tax-law provision that allowed both the deferral of gain and a one-time exclu- sion of a principal residence sale. Temporary rental of the home does not disqualify one from claiming the exclu- sion. The 2003 law requires only that you have occupied the house as your principal residence for the required period (two years out of five, extended). However, new legislation in 2009 requires that the “two years out of five (extended)” cannot start until the date the home is occu- pied as a principal residence for the first time. Under Internal Revenue Code Section 1031, taxpay- ers whose U.S. home may no longer qualify for the principal residence exclusion may be eligible to replace the property through a “tax-free exchange” (the so- called Starker Exchange). In essence, one property being rented out may be exchanged for another, as long as that one is also rented. In exchanging the properties, capital gains tax may be deferred. Technically, a simul- taneous trade of investments occurs. Actually, owners first sign a contract with an inter- mediary to sell their property, hold the cash proceeds in escrow, identify in writing within 45 days the property they intend to acquire, and settle on the new property within 180 days, using the money held in escrow as part of the payment. It is important to empha- size that the exchange is from one investment prop- erty to another investment property—the key factor in the IRS evaluation of an exchange transaction is the intent of the investor at the time the exchange was con- summated. The IRS rules for these exchanges are complex and specific, with a number of pitfalls that can nullify the transaction. An exchange should never be attempted without assistance from a tax lawyer specializing in this field. Calculating Your Adjusted Basis Many Foreign Service employees ask what items can be added to the cost basis of their homes when they are ready to sell. Money spent on fixing up the home for sale may be added to the