The Foreign Service Journal, February 2013

44 FEBRUARY 2013 | THE FOREIGN SERVICE JOURNAL AFSA NEWS Sale of a Principal Residence Current tax laws allow an exclusion of up to $500,000 for couples filing jointly and up to $250,000 for single taxpayers on the long-term gain from the sale of their principal residence. One need not 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. Since 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 for the first time. The only qualification for the capital-gains exclusion is that the house sold must have been owned and occupied by the taxpayer as his or her principal 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 dur- ing which the taxpayer has been away from the area on a Foreign Service assignment, up to a maximum 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 exclusion is not limited to a once-in-a-lifetime sale, but may be taken once every two years. When a principal resi- dence is sold, capital gains realized above the exclusion amounts are subject to taxa- tion. This exclusion replaces the earlier tax-law provision that allowed both the deferral of gain and a one-time exclu- sion of a principal residence sale. Temporary rental of the home does not disqualify one from claiming the exclu- sion. The 2003 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, taxpay- ers 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 deferred. Technically, a simul- taneous trade of investments occurs. Actually, owners first sign a contract with an inter- mediary to sell their property, hold the cash proceeds in escrow, identify in writing 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 empha- size 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 con- summated. 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 follow- ing conditions must be met: 1) the expenses must be for work performed during the 90-day period end- ing 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 improvements or replace- ments (these can be added to the basis of the property, the original purchase 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 qualify. 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 to Washington. Members of the Foreign Service are not 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 from state to state. In addition, there are numerous 2012 TAX GUIDE