The Foreign Service Journal, February 2012

A F S A N E W S ployment” (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, capital gains realized above the exclusion amounts are subject to taxation. This exclusion 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 fromclaiming the ex- clusion. 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). However, the 2009 legislation 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 exclusion may be el- igible to replace the property through a “tax-free exchange” (the so-called Starker Exchange). In essence, one prop- erty 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. Tech- nically, a simultaneous trade of invest- ments occurs. Actually, owners first sign a contract with an intermediary to sell their property, hold the cash proceeds in escrow, identify inwriting within 45 days the property they intend to acquire, 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 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 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 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 sale may be added to the basis. To qualify as legitimate fixing-up costs, the following conditionsmust bemet: 1) the expenses must 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 ex- penses must not be capital expenditures for permanent improvements or re- placements (these can be added to the basis of the property, the original pur- chase 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 qual- ify. State Tax Provisions Most Foreign Service employees have questions about their liability to pay state income taxes during periods when they are posted overseas or assigned toWash- ington. Members of the Foreign Service are not treated as domiciled in their coun- tries of assignment abroad. Every active- duty Foreign Service employee serving abroad must maintain a state of domi- cile in the United States, and the tax lia- bility that the employee faces varies greatly from state to state. In addition, there are numerous regulations con- cerning the taxability of Foreign Service pensions and annuities that vary by state. The “State Overviews” (see p. 38) briefly review the laws regarding in- come tax and tax on annuities and pensions as they affect Foreign Serv- ice personnel by state. Please note that while AFSA makes every at- tempt 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 readers to visit the state’s tax Web site (also listed). There are many criteria used in de- termining which state is a citizen’s domi- cile. One of the strongest determinants is prolonged physical presence, a stan- dard that Foreign Service personnel fre- quently 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, including where the individual has fam- ily 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 person has bank accounts or other financial holdings. In the case of Foreign Service em- ployees, the domicile might be the state from which the person joined the Serv- ice, where his or her home leave address 36 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 1 2