The Foreign Service Journal, February 2009

46 F O R E I G N S E R V I C E J O U R N A L / F E B R U A R Y 2 0 0 9 The only qualification for the capital- gains exclusion is that the house soldmust have been owned and occupied by the tax- payer as his or her principal residence for at least two of the last five years prior to the date of the sale. As stated above, the five- year periodmay be extended based on any period during which the taxpayer has been away from the area on a Foreign Service as- signment, up 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 in place of employment” (this would include foreign transfers). This exclusion is not limited to a once-in-a-lifetime sale, but may be taken once every two years. When a principal residence is sold, cap- ital gains realized above the exclusion amounts are subject to taxation. This ex- clusion replaces the earlier tax-law provi- sion that allowed both the deferral of gain and a one-time exclusion of a principal residence sale. Temporary rental of the home does not disqualify one fromclaiming the exclusion. The new tax law requires only that you have occupied the house as your principal residence for the required period (two years out of five, extended). Under Internal Revenue Code Section 1031, taxpayers whose U.S. home may no longer qualify for the principal residence exclusion may be eligible to replace the property through a “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 properties, capital gains tax may be de- ferred. Technically, a simultaneous trade of investments occurs. Actually, owners first sign a contract with an intermediary to sell their property, hold the cash pro- ceeds in escrow, identify in writing within 45 days the property they intend to ac- quire, and settle 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 fromone investment property 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 exchange was consummated. The IRS rules for these exchanges are com- plex and specific, with a number of pitfalls that can nullify the transaction. An ex- change should never be attemptedwithout 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 sale may be added to the basis. To qualify as legitimate “fixing-up costs,” the follow- ing conditions must be met: 1) the ex- pensesmust be for work performed during the 90-day period ending on the day on which the contract to sell the old residence was signed; 2) the expenses must be paid on or before the 30th day after sale of the house; and 3) the expenses must not be capital expenditures for permanent im- provements or replacements (these can be added to the basis of the property, the orig- inal purchase price, thereby reducing the amount of profit). A new roof and kitchen counters are not“fix-up”items. But paint- ing the house, cleaning up the garden and making minor repairs qualify. State Tax Provisions Members of the Foreign Service are not treated as domiciled in their countries of assignment abroad. Every active-duty For- eign Service employee serving abroad must maintain a state of domicile in the United States, and the tax liability that the employee faces varies greatly from state to state. In addition, there are numerous reg- ulations concerning the taxability of For- eign Service pensions and annuities that vary by state. This state guide briefly re- views the laws regarding income tax and tax on annuities and pensions as they af- fect Foreign Service personnel. Please note that while AFSA makes every attempt to provide the most up-to-date information, readers with specific questions should con- sult a tax expert in the state in question at the addresses given. We also encourage readers to visit the state’s taxWeb site, also listed. Most Foreign Service employees have questions about their liability to pay state income taxes during periods when they are posted overseas or assigned toWashington. There are many criteria used in determin- ing which state is a citizen’s domicile. One of the strongest determinants is prolonged physical presence, a standard that Foreign Service personnel frequently cannot meet due to overseas service. In such cases, the states will make a de- termination of the individual’s income-tax status based on other factors, including where the individual has family ties, where he or she has been filing resident tax re- A F S A N E W S T he Foreign Earned Income Ex- clusion allows U.S. citizens who are not government employees and are living outside the U.S. to ex- clude up to $85,700 of their 2008 for- eign-source income if they meet certain requirements. However, beginning in 2006, the IRS changed the requirement for how the excluded amount needs to be cal- culated. This affects the tax liability for couples with one member employed on the local economy overseas. Previ- ously, you took your total income and then subtracted your excluded income and paid tax on the remainder. The change now requires that you take your total income and figure what your tax would be, then deduct the tax that you would have paid on the ex- cludable income. For example: A Foreign Service employee earns $80,000. Teacher spouse earns $30,000. Before 2006: Tax on $110,000 minus $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 = $20,615 minus $3,749 = tax bill of $16,866. Increase in tax bill = $3,745. If you have questions about the im- plementation of this new regulation, please consult a financial professional. Foreign Earned Income — Important Change in IRS Rules