The Foreign Service Journal, February 2008

48 F OR E I GN S E R V I C E J OU R N A L / F E B R U A R Y 2 0 0 8 amounts are subject to taxation. This exclu- sion replaces the earlier tax law provision that allowed both the deferral of gains 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 these exchanges are complex and specific, with a number of pitfalls that can nullify the transaction. An exchange shouldnever 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 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 dayonwhich the contract to sell the old residence was signed; 2) the expenses must bepaidonor before the30thday after sale of the house; and3) the expensesmust 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 the house, cleaningup the garden and making minor repairs qualify as “fix- up costs.” State Tax Provisions Members of the ForeignService arenot treated as domiciled in their countries of assignment abroad. Every active-duty Foreign Service employee serving abroad must maintain 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 reg- ulations concerning the taxability of ForeignServicepensions andannuities that vary by state. The state guide briefly reviews the laws regarding income tax and tax on annu- ities and pensions as they affect Foreign Service personnel. Please note that while AFSAmakes every attempt to provide the most up-to-date information, readers with specific questions should consult a tax expert in the state in question at the addresses given. We also encourage read- ers to visit the states’ tax Web sites, also listed. Most Foreign Service employees have questions about their liability to pay state income taxes duringperiodswhen they are postedoverseas or assigned toWashington. There aremany criteria used indetermin- ingwhich state is a citizen’s domicile. One of the strongest determinants is pro- longed physical presence, a standard that Foreign Service personnel frequently can- not 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; A F S A N E W S T he Foreign Earned Income Exclu- sionallowsU.S. citizenswhoarenot government employees andare liv- ing outside the U.S. to exclude up to $85,700 of their 2007 foreign-source income if theymeet certain requirements. However, beginning in 2006, the IRS changed the requirement for how the excluded amount needs tobe calculated. This affects the tax liability for coupleswith onemember employedon the local econ- omy overseas. Previously, you took your total income and then subtracted your excluded income and paid tax on the remainder. The changenowrequires that you take your total income and figure what your taxwould be, then deduct the tax that you would have paid on the excludable income. For example: A Foreign Service employee earns $80,000. Teacher spouse earns $30,000. Before 2006: Taxon ($110,000minus $30,000) = tax on $80,000 = tax bill of $13,121. Now (2006 and later): Tax on $110,000 = $20,615; tax on $30,000 = $3,749; total tax=$20,615minus $3,749 = tax bill of $16,866. Increase in tax bill = $3,745. If you have questions about the implementation of this new regulation, please consult a financial professional. Foreign Earned Income — Important Change in IRS Rules