The Foreign Service Journal, February 2005

4 AFSA NEWS • FEBRUARY 2005 exchanged for another, as long as that one is also rented. In exchanging the prop- erties, capital gains tax may be deferred. Technically, a simultaneous trade of investments occurs. Actually, owners first sign a contract with an intermediary 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 newproperty 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 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 exchangewas con- summated. The IRS rules for the exchanges are complex and specific, with a number of pitfalls that can nulli- fy the transaction. An exchange should never be attempted without assistance froma 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 salemay be deducted from the sales price. To qualify as legitimate “fixing-up costs,” the following conditions must be met: 1) the expenses must be for work per- formed during the 90-day period ending on the day on which the contract to sell the old residencewasmade; 2) the expens- es must be paid on or before the 30th day after sale of the house, and 3) the expensesmust not be capital expenditures for permanent improvements or replace- ments (these can be added to the basis of the property, original purchase price, thereby reducing the amount of profit). A new roof and kitchen counters are not “fix-up” items. But painting the house, 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- ability of Foreign Service pensions and annuities 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 in the state in question at the addresses given. Information is also available on the states’ Web sites listed below. Most Foreign Service employees have questions about their liability to pay state income taxes during periods posted over- seas or assigned toWashington. It is a fun- damental rule of law that all U.S. citizens must have a domicile somewhere. There aremanycriteriaused indeterminingwhich state is a citizen’s domicile. One of the strongest determinants is prolongedphys- ical presence, a standard that ForeignService personnel frequently cannot meet, due to overseas service. In such cases, the states will make a determination of the individual’s income tax status based on other factors, includ- ing where the individual has family ties, where he or she has been filing resident tax returns, where he or she is registered to vote or has a driver’s license, where he or she owns property, or where the per- son has bank accounts or other financial holdings. In the case of Foreign Service employees, the domicilemight be the state fromwhich the person joined the Service, where his or her home leave address is, or where he or she intends to return upon separation. For purposes of this article, the termdomicile refers to legal residence; some states also define it as permanent residence. Residence refers to physical presence in the state. Foreign Service personnel must con- tinue to pay taxes to the state of domicile (or to theDistrict ofColumbia)while resid- ing outside of the state, including during assignments abroad, unless the state of res- idence does not require it. A non-resident, according to most states’ definitions, is an individualwhoearns income sourcedwithin the specific statebut does not live there or is living there for only part of the year (usually, less than six months). Individuals are generally con- sidered residents, and are thus fully liable for taxes, if they are domiciled in the state or if they are living in the state (usually at least six months of the year) but are not domiciled there. Foreign Service employees residing in the metropolitan Washington area are required to pay income tax to theDistrict, Maryland or Virginia, in addition to pay- ing tax to the state of their domicile. However,most states allowa credit, so that the taxpayer pays the higher tax rate of the two states, witheach state receiving a share. There are currently seven stateswithno state income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. In addition, New Hampshire and Tennessee have no tax on personal income but do tax profits from the sale of bonds and property. There are also eight stateswhich, under certain conditions, do not tax income earnedwhile the taxpayer is outside of the state: California, Connecticut, Missouri, New Jersey, New York, Oregon, Pennsylvania and West Virginia. The requirements for all except California are that the individual not have a permanent “place of abode” in the state, have a per- manent “place of abode” outside the state, andnot bephysicallypresent formore than 30 days during the tax year. California allows up to 45 days in the state during a tax year. Also, please note that these eight states require the filing of non-resident returns for all income earned fromin-state sources. Pennsylvania holds that “quarters provided by the government at no cost to petitioner cannot be considered as maintaining a permanent place of abode.” Thus members of the Foreign Service domiciled in Pennsylvania who occupy government housing overseas must pay income tax to Pennsylvania. If they rent their own home overseas, however, they will be exempt from these taxes. AFSA has not heard of a similar ruling in any