The Foreign Service Journal, February 2007

F E B R U A R Y 2 0 0 7 / F OR E I GN S E R V I C E J OU R N A L 59 cost, unless the loan is used for home improvements. The $100,000 ceiling applies to the total of all home equity loans youmayhave. The same generally applies to refinancing a mortgage. Points paid to obtain a refinanced loan cannot be fully deducted the same year, but must be deductedover the lifeof the loan. It is advis- able to save the settlement sheet (HUD-1 Form) fordocumentation in the event your tax return is selected by the IRS for audit. Qualified residences are defined as the taxpayer’sprincipal residence andoneother residence. The second home can be a house, condo, co-op,mobilehomeor boat, as long as the structure includes basic liv- ing accommodations, including sleeping, bathroomand cooking facilities. If the sec- ond 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 andmortgage inter- est may be deducted. Rental of Home Taxpayers who are overseas and rent- ed their homes in 2006 can continue to deduct mortgage interest as a rental expense. Alsodeductible arepropertyman- agement fees, condo fees, depreciationcosts, taxes and all other rental expenses. Losses up to $25,000 may be offset against other income, as long as theAGI does not exceed $100,000 and the taxpayer is actively managing the property. A taxpayer who retains a property manager does not lose 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, quali- fied individuals who were age 55 or older wereallowedaone-time capital-gains exclu- sionof $125,000. Also, under previous law, if youhadagainwhenyousoldyourhome, youcoulddefer all or part of the gain if you purchasedor built another home (of equal or higher value)within two years before or after the sale. The current tax laws allowan exclusion of up to $500,000 for couples filing joint- ly and up to $250,000 for single taxpayers on the long-termgain fromthe saleof their principal residence. Oneneednot purchase another residence 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. The only qualification for the capital- gains exclusion is that the house soldmust havebeen the taxpayer’s principal residence andownedby 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 maybe extendedbasedonanyperioddur- ingwhich the taxpayer has beenaway from the area on a Foreign Service assignment, to a maximum of 15 years (including the five years). There are some exceptions to the two-year requirement, including a sale due to a “change inplace of employment” (thiswould include foreign transfers). This exclusion is not limited to a once-in-a-life- time sale, butmay be takenonce every two years. Whenaprincipal residence is sold, cap- ital gains realized above the exclusion amounts are subject to taxation. This exclu- sion replaces the earlier tax-law provision that allowed both the deferral of gain and aone-timeexclusionof aprincipal residence sale. Temporary rental of thehomedoes not disqualifyone fromclaiming the exclusion. Thenewtax lawrequires only that youhave occupied the house as your principal res- idence for the required period (two years out of five, extended). Under Internal Revenue Code Section 1031, taxpayers whose U.S. homemay no longer qualify for the principal residence exclusion may be eligible to replace the property througha“tax-free exchange” (the so-calledStarkerExchange). Inessence, 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- ments occurs. Actually, owners first sign a contractwithan intermediary to sell their property, hold the cashproceeds inescrow, identify inwritingwithin45days the prop- erty they intend to acquire, and settle on thenewpropertywithin180days, using the money held in escrow as part of the pay- ment. It is important to emphasize that the exchange is fromone 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 IRS rules for the 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 spe- cializing 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 expensesmust be for work performed during the90-dayperiodendingon theday on which the contract to sell the old resi- dencewas signed; 2) the expensesmust be paid on or before the 30th day after sale of the house, and; 3) the expenses must not be capital expenditures for permanent improvements or replacements (these can be added to the basis of the property, the original purchase price, thereby reducing the amount of profit). A new roof and kitchencounters arenot “fix-up” items. But painting thehouse, cleaningup the garden, and making minor repairs qualify as “fix- up costs.” State Tax Provisions Every active-duty Foreign Service employee serving abroadmustmaintain a state of domicile in the United States, and the tax liability that the employee faces varies greatly fromstate to state. Inaddition, there are numerous regulations concerning the taxability of Foreign Service pensions and annuities that vary by state. This state guide briefly reviews the laws regarding income tax and tax on annuities A F S A N E W S