The Foreign Service Journal, February 2011

F E B R U A R Y 2 0 1 1 / F O R E I G N S E R V I C E J O U R N A L 59 ciation taken afterMay 7, 1997, will, however, be recaptured (added to income) at the time of sale, and taxed at 25 percent. As we note, however, under “New for 2009 and 2010” on p. 55, after January 2009 gain from the sale of a home can no longer be excluded from gross income for periods when it was rented out before you occupied it as a principal residence. The only qualifi- cation for the capital-gains exclusion is that the house sold must have been owned and occupied by the taxpayer as his or her princi- pal residence for at least two of the last five years prior to the date of the sale. For the Foreign Service, the five-year period may be extended by any period during which the taxpayer has been away from the area on a Foreign Service assignment, up to a maxi- mum of 15 years (including the five years). There are some exceptions to the two-year occupancy requirement, including a sale due to a “change in place of employment” (this would include foreign transfers). This exclu- sion is not limited to a once-in-a-lifetime sale, but may be taken once every two years. When a principal residence is sold, capi- tal 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 a one-time exclusion of a principal residence sale. Temporary rental of the home does not disqualify one from claiming the exclusion. The new tax law requires only that you have occupied the house as your principal resi- dence for the required period (two years out of five, extended). However, the 2009 legisla- tion requires that the “two years out of five (extended)” cannot start until the date the home is occupied as a principal residence for the first time. Under Internal Revenue Code Section 1031, taxpayers whose U.S. home may no longer qualify for the principal residence ex- clusion may be eligible to replace the prop- erty 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 deferred. Technically, a simultaneous trade of investments occurs. Actually, own- ers 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 set- tle on the new property within 180 days, using themoney held in escrow as part of the payment. It is important to emphasize that the ex- change is from one investment property to another investment property — the key fac- tor 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 complex and specific, with a number of pitfalls that can nullify the transaction. An exchange 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 le- gitimate fixing-up costs, the following con- ditions must bemet: 1) the expenses must be for work performed during the 90-day pe- A F S A N E W S