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June 30, 2015 - Phil Hodgen

Personal residence exclusion under exit tax rules

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This post is for people who are covered expatriates and own their home.

American citizens who give up their American citizenship (expatriates) are classified into covered expatriates and non-covered expatriates. A covered expatriate is subject to a “mark to market” rule, where the US pretends that the covered expatriate sold all his property on the day before expatriation and imposes a tax on the gain from the pretend sale.

Normally, you get a personal residence exclusion of $250,000 when you sell your principal residence. The question is: Do you get the exclusion for the pretend sale under mark to market?

Summary

If you actually sell your principal residence, you get a $250,000 exclusion from the gain. It’s not clear whether you get the exclusion when you calculate the gain for exit tax purposes. If it is feasible to sell the residence, consider doing so in preparation for expatriation.

You have to determine whether you get a personal residence exclusion

Normally, if you sell real property, and the real property is your principal residence, then you get to exclude the first $250,000 of gain from tax calculations. IRC §121(a), (b)(1). This is known as the personal residence exclusion.

Section 877A(a)(1) imposes a mark to market rule on covered expatriates as follows:

All property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value. IRC §877A(a)(1).

You are a covered expatriate, so you are treated as having sold your home on the day before expatriation. You now have to decide whether you get to exclude the first $250,000 of gain.

Section 877A(a)(2)(A) provides a special rule for the gain from the sale:

Notwithstanding any other provision of this title, any gain arising from such sale shall be taken into account for the taxable year of the sale… IRC §877A(a)(2)(A).

This rule overrides all other rules under “this title”, otherwise known as the Internal Revenue Code. You need to decide whether “shall be taken into account” means “you must apply tax to the entire gain from selling the home” or something else.

The IRS has not provided clear guidance on exclusions

The IRS has not said anything specific about whether section 877A(a)(2)(A) bars normal exclusion rules. You will need to determine how it affects the personal residence exclusion based on other factors.

There is a special exit tax exclusion that seems to be the sole exclusion from income for market to market properties

Section 877A(a)(3)(A) provides a special exit tax exclusion as follows:

The amount which would (but for this paragraph) be included in the gross income of any individual by reason of paragraph (1) shall be reduced (but not below zero) by $600,000. IRC §877A(a)(3)(A).

The exclusion is indexed for inflation each year. It is $690,000 for 2015. Rev. Proc. 2014-61, §3.31; 2014-2 C.B. 860.

The “but for this paragraph” part implies that if the exit tax exclusion did not exist, then any gain recognized under the mark to market rule will be included in gross income.

Under section 121, the personal residence exclusion works as follows:

Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more. IRC §121(a).

The personal residence exclusion is an exclusion from gross income. The wording of the mark to market rule implies that the exit tax exclusion replaces the personal residence exclusion.

Form 8854 merely confuses the matter

When you expatriate, you must file an expatriation return on Form 8854. Notice 2009-85, §8.C; 2009-2 C.B. 598. Part IV, section B, line 8 is where you calculate “recognition of gain or loss on the deemed sale of mark-to-market property”, i.e. property treated as having been sold on the day before expatriation under section 877A(a)(1).

Form 8854, Part IV, section B, line 8 has the following columns:

  • (a) description of property
  • (b) fair market value on day before date of expatriation
  • (c) cost or other basis
  • (d) gain or (loss). Subtract (c) from (b)
  • (e) gain after allocation of the exclusion amount (see instructions)
  • (f) form or schedule on which gain or loss is reported
  • (g) amount of tax deferred (attach computations)

Column (e) is the column where you calculate the gain under mark to market. Column (f) is where you flow the gain to the property form or schedule. Form 8854 instructions say:

You must report and recognize the gain (or loss) of each property reported in line 8, column (a), on the relevant form or schedule of your Form 1040 for the part of the year that includes the day before your expatriation date. The return to which you attach your form or schedule will depend on your status at the end of the year. See chapter 1 of Pub. 519 to determine which form you should file. The gain from column (e) or loss from column (d) attributable to each property is reported in the same manner as if the property had actually been sold. For example, gain recognized from the deemed sale of a rental property that has been depreciated is reported on Form 4797 as if it had actually been sold. Gain recognized from the deemed sale of personal property (such as stock or a personal residence) is reported on Form 8949 as if it had been sold… Form 8854 instructions, 6 (2014).

There are two conflicting rules in the Form instructions:

First, Form 8854 requires you to report “the gain from column (e) or loss from column (d)”. This part implies that the gain you report must be the same as the gain in column (e). Form 8949, which is where you report gain from the sale of a personal residence, has the following columns:

  • (a) description of property
  • (b) date acquired
  • (c) date sold or disposed
  • (d) proceeds
  • (e) cost or other basis
  • (f) code(s) from instructions
  • (g) amount of adjustment
  • (h) gain or (loss)

On Form 8949, the gain is reported after adjustments such as the personal residence exclusion. Reporting the gain from column (e) implies that you report the gain directly, skipping the personal residence exclusion.

Second, Form 8854 requires you to report the gain from a property “in the same manner as if the property had actually been sold.” This part implies that the gain you report is subject to the same rules as if you had actually sold the property. If you had actually sold the personal residence, then you would get the $250,000 personal residence exclusion.

Form 8854 merely adds to the confusion.

Consider actually selling your home

Let’s say you own a personal residence with a gain of $500,000. You own an investment property with built-in gain of $500,000. And you own stocks with built in gain of $500,000.

If you expatriate and subject each property to mark to market, and it turns out that you don’t get the personal property exclusion then each property gets an exclusion of $230,000 (500,000/1,500,000)*690,000=230,000). You must pay tax on $810,000 of gain.

If you expatriate and subject each property to mark to market, and it turns out that you get the personal property exclusion then each property gets an exclusion of $230,000 (500,000/1,500,000)*690,000=230,000). But the personal residence also gets a $250,000 exclusion. You must pay tax on $560,000 of gain.

If you actually sell your personal residence, then you get the personal residence exclusion of $250,000. Then, upon expatriation, your investment property and stocks each get $345,000 of exclusion. You pay tax on $560,000 of gain only.

There’s no economic incentive, at least from the US tax side, to keep the personal residence and pay the exit tax. Considering selling it in preparation for expatriation, assuming selling your personal residence does not cause other problems.

Disclaimer

This newsletter is not tax advice. Get advice from a tax adviser before you try this at home.

Send me your questions!

Phil.

Expatriation