The Foreign Service Journal, January-February 2022

AFSA NEWS 60 JANUARY-FEBRUARY 2022 | THE FOREIGN SERVICE JOURNAL Circular 230 Notice: Pursuant to U.S. Treasury Department Regulations, all tax advice herein is neither intended nor written to be used, and may not be used, for the purposes of avoiding tax-related penalties under the Internal Revenue Code or promoting, marketing or recommending advice on any tax-related matters. erty for tax reporting purposes, calculate deductible expenses (including depreciation), account for income derived from the property and file correct tax forms on time each year. Readers should note that the depreciable basis of the property must be adjusted for prior mandatory depreciation deductions when a previously rented property converts back to rental use after a period of personal use. Failure to include the proper amount of depreciation on the Schedule E can result in an incorrect accounting method, which may require a change in accounting method (Form 3115) or an amended return, depending on the mistake made and/or the number of years depreciation was improperly reported on the Schedule E. AFSA recommends also reading Tax Topics 703 (basis), 704 (depreciation) and 414 (rental property); the Schedule E and Form 1040 instructions; IRC Sections 167 (depreciation), 1012 (cost basis), 1011 (adjusted basis) and 1016 (adjustments to basis); associated basis and depreciation regulations; and Publications 527 and 946. Selling a Principal Residence—IRC Section 121 Taxpayers who sell real estate used as a principal residence at some time during the taxpayer’s ownership may qualify to exclude all or a portion of their net taxable capital gain under the provisions of IRC Section 121. A taxpayer who used the property as a principal residence and also rented out the property can only exclude the qualifying IRC Section 121 capital gain, which is the capital gain other than the gain created under IRC Section 1250 (see below for a discussion of IRC Section 1250). IRC Section 121 allows an exclusion of qualifying capital gain up to $500,000 MFJ or $250,000 for all other filing statuses. To qualify for the full IRC Section 121 exclusion, the taxpayer(s): (1) must have owned the home and lived there at any time for at least two of the last five years before the date of the sale (but see Military Families Relief Act, below); (2) can- not have acquired the home in a 1031 exchange within the five years before the date of the sale; and (3) cannot have claimed this exclusion during the two years before the date of the sale. An exclusion of gain for a fraction of these upper limits may be possible if one or more of the above requirements are not met. Taxpayers who sell their principal residence for a profit of more than $250,000 ($500,000 for MFJ) will owe capital gains tax on the excess. Additionally, capital gain attributed to periods of nonqualified use cannot be excluded under IRC Section 121. AFSA recommends Topic 701, Publication 523, IRC Sec. 121, and related regulations. Military Families Tax Relief Act of 2003 According to the Military Families Tax Relief Act of 2003, the five-year period to qualify for the exclusion under IRC Section 121 may be suspended for members of the Foreign Service for up to 10 years during which the taxpayer has been on a qualifying Foreign Service assignment. This act also excludes periods of “qualified official extended duty” from nonqualified use treatment. In addition to the recommended reading from the previous section, AFSA recommends IRC Sec. 121(d)(9) and 26 CFR Sec. 1.121-5. Selling a Property That Was Previously Rented— IRC Section 1250 Taxpayers who sell a property that was used as a rental prop- erty at any time during the taxpayer’s ownership must reduce the property’s adjusted basis by the mandatory depreciation required during the rental period of the property (even if the taxpayer did not properly claim depreciation deductions) before calculating the final net taxable capital gain from the property sale. The portion of the net capital gain created from the manda- tory depreciation (whether or not claimed during the rental period(s)) is taxed as IRC Section 1250 unrecaptured gain and is not eligible for capital gain exclusion under IRC Section 121. The portion of the remaining net capital gain is eligible for exclusion under IRC Section 121 if all requirements are met. Due to the impact of IRC Section 1250 unrecaptured gain rules, taxpayers who sell a property that was previously rented often still have a tax bill due even if they qualify to exclude a portion of their net capital gain under IRC Section 121. AFSA recommends Topic 701, Publication 523, IRC Sec. 1250, and related regulations. Non-Rental Business Use of Home Although most Foreign Service families find themselves in government-funded housing overseas much of the time, some may own property in the United States that they both occupy for personal purposes and use to operate a private business on the side. To qualify for a deduction for business-related expenses for a portion of a residence used for a business, a taxpayer must use a portion of their home exclusively and regularly as a principal place of business (and file a Schedule C to report the business activity). A taxpayer who meets that threshold must then either calculate the actual expenses of the home office—e.g., cost of a business phone line and part of state and local property taxes, utilities, mortgage interest and depreciation—or use the IRS’ simplified method based on a flat rate for the square footage used for business (up to a maximum of 300 square feet). Also