Green cards, expatriation, and basis step-up

by Phil Hodgen on October 21, 2012

This is for those green card holders out there who are giving up their permanent resident visa status in the United States, and who have held the green card visa “in at least 8 of the last 15 years.”

If you fit into this category, when you give up your green card you are going to be an “expatriate” for purposes of the exit tax.  You may or may not have to pay an actual tax.  If you are a “covered expatriate” you will have to pay tax.  If you are not a “covered expatriate” you won’t have to pay tax.  Instead, you will just file a large and complex tax return for the year you give up your green card.

This post is not about whether you are a covered expatriate, an expatriate, etc.  I am going to assume that you are a covered expatriate — you are going to pay some tax.  The question is how much.

The “mark-to-market” rules say that everything you own (with some exceptions) is treated as if you (a covered expatriate) sold it on the day before you terminated your green card.  Section 877A(a)(1) says:

“All property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value.”

We know what the sale price will be–the property’s fair market value on the day before you gave up the green card.  But what is your tax basis?  Sale price minus tax basis = capital gain, and that is what you will be taxed on when you terminate your green card.

For someone who is a green card holder (or naturalized citizen, for that matter), tax basis can be one of two things:

  • The actual tax basis calculated according to the normal rules (acquisition cost plus capital improvements minus depreciation); or
  • The value of the property when you first became a resident of the United States.

Specifically, Section 877A(h)(2) says:

Solely for the purpose of determining any tax imposed by reason of subsection (a), property which was held by an individual on the date the individual first became a resident of the United States (within the meaning of section 7701(b)) shall be treated as having a basis on such date of not less than the fair market value of such property on such date. The preceding sentence shall not apply if the individual elects not to have such sentence apply. Such an election, once made, shall be irrevocable.

Mandatory; elect out

This is mandatory. The Code says the basis “shall” be not less than the fair market value of the property on that day.

Example

Fred owns publicly traded stock. He bought it for $100,000. When he entered the United States and became a resident, the stock was worth $200,000. Solely for purposes of the exit tax, his tax basis is $200,000. If he is a covered expatriate and terminates his green card and the stock is worth $250,000 on that day, his taxable mark-to-market gain is $50,000.

Example

Fred owns publicly traded stock. He bought it for $100,000. When he entered the United States and became a resident, the stock was worth $50,000. Solely for the purposes of the exit tax, his tax basis is $100,000. His tax basis cannot be less than the fair market value when he becomes a resident, but it can be more. If he is a covered expatriate and he terminates his green card and the stock is worth $250,000 at that time, he has a mark-to-market gain of $150,000.

The Code says Fred can elect out of this treatment. He can elect to have his historical tax basis used for purposes of the exit tax, if he wants to.

How to become a resident

Section 7701(b) lists the ways that a person becomes a U.S. resident. If you satisfy one of these, this step-up in basis rule will apply to you.

  • Green card. You are a “lawful permanent resident” of the United States any time during the year. Section 7701(b)(1)(A)(I).
  • Too many days. You meet the “substantial presence test” for a calendar year. This means you spent a sufficient number of days in the United States in the current and two prior years to satisfy a mathematical test and you became a resident for income tax purposes.Section 7701(b)(1)(A)(II).
  • Special election. You made a special election specified in Section 7701(b)(4) to be a U.S. resident. Section 7701(b)(1)(A)(III).

Why it is fair to citizens, too

Citizens of the United States who expatriate are covered by this rule, too. For someone who entered the United States, became a resident, then a citizen, then expatriated, Section 877A(h)(2) grants a step-up in basis equal to the value on the date that residency commenced. The fact that residency later became citizenship does not matter.

And perversely, the rule applies to citizens born in the United States, too. Someone who is born in the United States will be acquire tax residency immediately upon birth. So that new-born soul is entitled to a step-up in basis on all of the assets that he or she owns at the moment of birth. The Internal Revenue Code is full of justice and equality.

But not U.S. real estate

The IRS, in Notice 2009-85, Section 3(D), has said that they do not intended to allow this step-up in basis rule to apply to U.S. real estate:

The IRS and Treasury Department intend to exercise their regulatory authority to exclude from this step-up-in-basis rule United States real property interests within the meaning of section 897(c) (“USRPIs”) and property used or held for use in connection with the conduct of a trade or business within the United States.

This means that an immigrant who bought U.S. real estate while a nonresident will not be able to step up the basis of that real estate to fair market value effective on the first day of residency.

Example

Fred is a resident and citizen of Ireland.  He buys U.S. real property while he is a nonresident of the United States.  Later becomes a resident of the United States and gets a green card.  Years later, as a covered expatriate, he wants to calculate his mark-to-market gain.  He must use his historical tax basis for the U.S. real property.  He cannot use the fair market value of the U.S. real property on the day that he became a U.S. resident.

Yeah.  The IRS hasn’t written the rules yet.  So what do you do?  Dirty Harry wants to know.

Is this our next IRS Commissioner?

Reader comments (3)

  • I know this is arguably a bit off topic, but I find it exceedingly strange that MTM even applies to US real property. Why?? US real property remains fully taxable even after expatriation, so there’s no need to impose tax upon exit. If Phil or anyone else can come up with a plausible rationale, please do let me know!

  • Dear Mr Hodgen, this is perhaps a bit away from this particular blog topic, but I am wondering if you would be kind enough to help me understand something. You mentioned people expatriating “who have held the green card visa in at least 8 of the last 15 years”. If, for example, I am a green card holder and have been so in only 7 of the last 15 (calendar) years, does that mean I am completely outside this whole exit tax system? (Pls assume that all tax returns are lodged up to date and that a final dual status return is also going to be lodged and that I am definitely well below the various thresholds for being a covered expatriate). Will I be able to avoid lodging Form 8854, given the specific referencing in that form to long-term LPRs and citizens, and I will not be within the definition of ‘long term’ (I would not be able to answer Q5 on the form, for example, since there is no applicable box to check)? If I do not need to lodge form 8854, is there anything else I need to do to inform the IRS and/or protect myself from future IRS questions? (how would they know that I am not a long term resident and therefore outside the requirements for lodging 8854? Are they likely to simply assume I have failed to lodge 8854 when I should have, and come after me when they receive my final dual status return?) Would I be better off ‘pretending’ to meet the long term requirement and lodging 8854 anyway (I prefer not to since I don’t want to sign false declarations, and also to avoid the complexities of sorting through 8854 anyway!!)? Thanks so much for your advice and time, I look forward to it!

  • Phil Hodgen says Nov 6, 2012 10:14 am

    I did a blog post in response, based on a real-life situation going on right now for a real-life relinquisher of a green card.

    If you received your green card in 2006 or later and you cancel your green card in 2012, then you will not have held the green card long enough to become a “long-term resident.” Since only long-term residents and citizens can be subjected to the exit tax rules (including Form 8854), you win. You successfully avoid filing Form 8854. Just file the dual status year tax return and you’re done.

    /Phil.