My earlier blog post discussed the rules that apply to a US taxpayer who sells his personal residence, whether located abroad or in the US. If the home qualifies as the “principal residence” and other requirements are satisfied the taxpayer may exclude up to US$250,000 ($500,000 for joint returns) of taxable gain from income. As explained in the earlier post, more nuances for claiming this exclusion are involved when the US taxpayer is living and working abroad.
Today’s blog post will examine how this gain exclusion rule may apply to the “covered expatriate” who is deemed to sell his principal residence on the day before the expatriation date.
“Covered Expatriates” and the Exit Tax
Certain individuals who give up their US citizenship or their green cards are subject to the so-called “exit tax” imposed under Section 877A of the Internal Revenue Code (Code). Under certain “expatriation” tax rules, harsh tax consequences will result if the individual giving up US citizenship or “long-term” permanent residency (generally, this is an individual who has held a green card for 8 out of the past 15 years) is a so-called “covered expatriate”. Only “covered expatriates” will suffer the onerous tax consequences.
One is a “covered expatriate” if the individual has either a net worth of US$2 million at the time of expatriation; or, if he has a certain average income tax liability over the past 5 years prior to expatriation. For calendar year 2022, an individual is a covered expatriate if the individual’s “average annual net income tax” for the five taxable years ending before the expatriation date is more than US$178,000. Remember, this is the average income tax for which the individual was liable; it is not the amount of income earned.
An individual is also treated as a “covered expatriate” if the person fails to notify the Internal Revenue Service (IRS) that he has expatriated and satisfied all of his tax liabilities for the past five years. This is accomplished by filing IRS Form 8854, which is due in the calendar year following the year of expatriation. Failure to file the form means “covered expatriate” status can result even if the taxpayer did not meet the “net worth” or “income tax liability” dollar thresholds.
Filing the Form 8854 is critical in the world of expatriation, but don’t panic if you have neglected to file it. The IRS now has a relief procedure available for expatriates who failed to file the Form 8854. If you need help with this procedure we are here to assist.
For those seeking further information on the general tax issues associated with expatriation, please see my blog post here and my “Expatriation” blog category with all posts on the topic.
Exit Tax and the Principal Residence
Today’s blog post will focus on the exit tax and treatment of deemed gain on the personal residence upon expatriation. The exit tax is what is known as a “mark-to-market” rule. Under this rule, the individual is subject to tax on the net unrealized gain on all of his worldwide assets as if such property were sold for its fair market value on the day before the expatriation date. Thus, the individual must pay US income tax on gain that he is “deemed” to have earned by operation of the exit tax rules, when in fact, the individual has not sold anything and is without any cash in hand to pay the tax. In other words, the law “pretends” the individual has sold all of his assets and tax will be owed on the “pretend” gain, if any.
A covered expatriate is permitted to exclude from tax a certain amount of gain that is deemed earned under the mark-to-market rule. The exclusion amount is indexed annually for inflation. For the 2022 calendar year, the exclusion amount is US$767,000. However, according to the IRS’ interpretation, the gain exclusion rule does not permit a straightforward reduction of the expatriate’s total gain. Special pro-rata allocations are required with regard to the various assets having built-in gain. See IRS Notice 2009-85 at Section 3, B.
Principal Residence Owned By “Covered Expatriate”
If the “covered expatriate” owns a home (whether in the US or overseas), the question arises as to how the exit tax will apply upon the deemed sale of that residence (assuming it qualifies as the “principal residence” for purposes of Section 121 of the Code). The exit tax rules are ambiguous and the law is unclear as to how the expatriation rules should apply to the situation. A true sale of that home would qualify for gain exclusion under Section 121, but what about a “pretend” sale?
Significantly, Code Section 877A(a)(2)(A) provides “[N]otwithstanding any other provision of this title, any gain arising from a [mark-to-market sale] shall be taken into account for the taxable year of the sale….” This means that the mark-to-market rules will take precedence over any other Internal Revenue Code section that might otherwise treat the gain as non-taxable.
The issue depends on how one interprets Code Section 877A(a)(2)(A) .
- On the one hand, it could be interpreted to require the taxable gain on the deemed sale of the personal residence to be fully taxed, with the only permissible reduction in taxable gain being the exclusion amount allowed by Code Section 877A(a)(3)(A) (for 2022, this is US$767,000).
- On the other hand, the rule could be interpreted as an instruction for calculation of the taxable gain on the deemed sale of world-wide assets, including the personal residence, and then permitting use of the Section 121 exclusion to reduce that taxable gain by US$250,000 (US$500,000 if the house is owned jointly and both spouses are expatriating). Any remaining taxable gain is then further reduced by the US$767,000 allowed by Code Section 877A(a)(3)(A).
Unfortunately, neither the Form 8854, its instructions nor the only current guidance we have from the IRS in Notice 2009-85 provide any assistance on this question.
It should be noted that Code Section 121(e) provides a denial of the exclusion on the sale or exchange of the personal residence for any expatriate who is subject to the provisions of Code Section 877(a)(1). Code Section 877(a)(1) applies only to certain expatriates who expatriated on or before June 17, 2008. The expatriation rules were very different under the regime in effect at that time. In part, those old rules continued to tax the expatriate on certain items of US-source income for a 10-year period after expatriation. The rules contained in Section 877A, the current expatriation regime, are very different. They do away with this 10-year “shadow” period and apply instead, the exit tax as well as impose other repercussions on any US individual receiving gifts or bequests from the “covered expatriate”. Arguably the Section 121 exclusion should apply since Congress did not explicitly amend Section 121(e) to prohibit its application when it enacted the current expatriation regime for those expatriating after June 17, 2008.
Careful Planning is Key
Anyone who is contemplating expatriation must obtain sound tax advice well beforehand. It is possible that with careful planning the individual can avoid being treated as a “covered expatriate” in the first place. This is the best case scenario. If it is not possible, a thorough review of all assets should be undertaken. In the case of the principal residence, it may be best for the “covered expatriate” to sell the home prior to expatriation in order to be able to unequivocally claim the Section 121 exclusion on sale.
If the principal residence is in the US, this is the wisest course of action since the individual will no longer remain in that house and any gain exceeding the amount permitted to be excluded under Section 121 will be taxed whether the residence is sold by the individual while he remains a US person or after he becomes a nonresident alien. If the principal residence is located abroad, other factors will come into play. For example, the individual may not wish to sell that residence because he will continue to live in the country where it is located. The possibility of taxation in the foreign country if the residence is sold must also be considered and carefully examined.
You can listen to a podcast on this topic in which I discuss the nuances with US and Canadian attorney John Richardson. John’s Tweet on the topic is here. John and I have worked together on numerous cases. His professional practice focuses on assisting US citizens and green card holders who live outside the United States who face unique issues such as the one involved in the subject of this post.
Expatriation is a big step and the IRS is looking more closely at all expatriates; it is now an audit hotspot and has been made the subject of a special IRS campaign. Look before you leap and get expert tax advice from a seasoned professional. This is an area in which I have decades of experience. Let me know if you need expatriation advice.
Posted January 6, 2022
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