The Foreign Service Journal, February 2004

FEBRUARY 2004 • AFSA NEWS 5 be claimed either, but all property taxes and mortgage interest may be deducted. Rental of Home Taxpayers who are overseas and rented their homes in 2003 can continue to deductmortgageinterestasarentalexpense. Also deductible are property management fees,condofees,depreciationcosts,taxesand all other rental expenses. Losses up to $25,000maybeoffset againstother income, as longas theAGIdoesnot exceed$100,000 and the taxpayer is actively managing the property. Retainingapropertymanagerdoes not mean losing this benefit. Sale of a Principal Residence The current capital-gains exclusion on the sale of a principal residence on or after May 7, 1997, applies to all homeowners regardless of their age. Previously, qualified individuals whowere age 55 or older were allowed a one-time capital-gains exclusion of $125,000. Also, under previous law, if you had a gainwhen you sold your home, youcoulddefer all or part of the gain if you purchasedor built another home (of equal or higher value)within twoyears before or after the sale. The current tax laws allowanexclusion of up to $500,000 for couples filing jointly and up to $250,000 for single taxpayers on the gain fromthe saleof their principal res- idence. All depreciation takenafterMay 7, 1997, will, however, be recaptured (added to income) at the time of sale, and taxed at 25 percent. The only qualification for the capital- gains exclusion is that the house soldmust havebeen the taxpayer’sprincipal residence and owned by the taxpayer for at least two of the last five years prior to the date of the sale. As stated above, the five-year period may be extended based on any period in whichthetaxpayerhasbeenoutsidetheU.S. on Foreign Service assignment, to a maxi- mumof 15 years (including the five years). There are some exceptions to the two-year requirement, including a sale for the “change in place of employment” reason (this would include foreign transfers). This exclusion is not limited to a once-in- a-lifetime sale, butmaybe takenonce every two years. Whenaprincipal residence is sold, cap- ital gains realized above the exclusion amountsaresubjecttotaxation. Thisexclu- sionreplacestheearliertax-lawprovisionthat allowedboth thedeferral of gainandaone- time exclusionof a principal residence sale. Temporary rental of thehomedoesnot disqualifyone fromclaiming the exclusion. Thenewtax lawrequiresonly that youhave occupied the house as your principal resi- dence for the requiredperiod(twoyearsout of five, extended). Under Internal Revenue Code Section 1031, taxpayers whose U.S. home may no longer qualify for the principal residence exclusionmaybeeligibletoreplacetheprop- erty througha “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 proper- ties, capital gains tax may be deferred. Technically, a simultaneous tradeof invest- mentsoccurs. Actually,ownersfirstselltheir property, place the equity proceeds in escrow, identify in writing within 45 days theproperty they intend toacquire, andset- tle on the new property within 180 days, using the money held in escrow as part of the payment. It is important to emphasize that the exchange is from one investment proper- ty 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 exchangewas con- summated. The IRSrules for theexchanges are complex and specific,withanumber of pitfalls that can nullify the transaction. An exchange shouldnever be attemptedwith- out assistance from a tax lawyer specializ- ing in this field. Calculating Your Adjusted Basis ManyForeignServiceemployeesaskwhat 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 salemay be deducted from the sales price. To qual- ify as legitimate “fixing-up costs,” the fol- lowing conditions must be met: 1) the expensesmust be forworkperformeddur- ing the 90-dayperiod endingon the dayon which the contract to sell the old residence wasmade; 2) the expensesmust be paidon orbeforethe30thdayaftersaleofthehouse, and 3) the expenses must not be capital expendituresforpermanentimprovements or replacements (these can be added to the basisoftheproperty,originalpurchaseprice, thereby reducing the amount of profit). A newroof andkitchen counters are not “fix- up” items. Butpainting thehouse, cleaning up the garden, and making minor repairs qualify as “fixing-up costs.” STATE TAX PROVISIONS Every active Foreign Service employee serving abroad must maintain a state of domicile in the United States, and the tax liability that the employee faces varies great- ly fromstate to state. In addition, there are numerous regulations concerning the tax- abilityofForeignServicepensionsandannu- ities that vary by state. This state guide briefly reviews the laws regarding income tax and tax on annuities andpensions as they affect ForeignService personnel. Please note that while AFSA makes every attempt to provide the most up-to-date information, readers with spe- cific questions should consult a tax expert inthestateinquestionattheaddressesgiven. Information is also available on the states’ Web sites listed below. Most Foreign Service employees have JOSH