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July 8, 2016 - Haoshen Zhong

Stealth Change to the Exit Tax for Green Card Holders?

Greetings from Haoshen Zhong.

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Do I get a step up in basis if I am a green card holder who becomes a covered expatriate?

This week’s newsletter came about because of a bit of intra-office panic:

Do green card holders who expatriated in 2015 still get a step up in basis for exit tax purposes?

Why did this question arise? Because we noticed that the 2015 form contains a slight change from the previous year. I will discuss exactly what that change was in a moment, and why it led to this question. But first, some background on the exit tax.

Background on the exit tax

Covered expatriates are subject to an exit tax when they expatriate. IRC §877A. One of the components of the exit tax is assessed on the gain from a pretend sale of everything the covered expatriate owned on the day before expatriation. IRC §877A(a).

There is a definition of “covered expatriate”, which I will not go into in this newsletter. It is sufficient for our purposes to know that a green card holder who had permanent resident status for “long enough” (which I will also not go into in this newsletter) can potentially become a covered expatriate when he loses his permanent resident status. IRC §877A(g).

Step up in basis for permanent residents

Recall that one component of the exit tax requires the covered expatriate to calculate gains on a pretend sale of all his assets on the day before expatriation. IRC §877A(a). This requires him to know the adjusted bases of all his assets on the day before expatriation.

There is a special provision that allows a green card holder to step up his basis: If, on the day the green card holder first became a US tax resident (not necessarily the day he first became an immigration permanent resident), the fair market value of his assets are higher than the adjusted bases in the assets on the day he became a US tax resident, then for exit tax purposes, the adjusted bases of his assets on the day he became a US tax resident is used as the adjusted bases on that day. IRC §877(h)(2). Any adjustments to bases afterwards are applied normally.

To put this into an example:

  1. On 2001-01-01, a nonresident alien buys a house for $1,000,000. His cost basis in the house is $1,000,000.
  2. On 2002-02-02, the nonresident alien makes $300,000 of improvements to the house. His adjusted basis in the house is now $1,300,000.
  3. On 2003-03-03, he acquires permanent residence and arrives in the US. He becomes a US resident on this date. At this time, the house has a fair market value of $1,500,000.
  4. On 2005-05-05, he makes another $100,000 of improvements to the house.
  5. On 2015-01-01, he abandons his permanent residence and becomes a covered expatriate. The house has a fair market value of $2,500,000.

Under this scenario, on the day the covered expatriate became a US resident, the fair market value of the house was $1,500,000, but his adjusted basis in the house was $1,300,000. Therefore, for exit tax purposes, we take $1,500,000 as his adjusted basis in the house as of the date he became a US resident. Afterwards, he made another $100,000 of improvements, so his adjusted basis became $1,600,000. His exit gain is $2,500,000 – 1,600,000 = 900,000.

Why the panic?

An expatriate (covered or not) must file Form 8854 with his tax return for the year of expatriation. Part V, Schedule A of Form 8854 requires the covered expatriate to complete a balance sheet listing all his assets. Column (a) asks for fair market value. Column (b) asks for adjusted basis. Column (c) asks for gain. Column (d) asks for fair market value on the beginning date of US residency.

On the 2015 form, the balance sheet says “[taxpayers who expatriated in 2015] do not complete column (d)”. This was not part of the 2014 or earlier forms. It seems the IRS is now telling the green card holder, “Do not tell us what the fair market value of the property on the day you became a US resident was.”

Does this mean that starting in 2015, green card holders no longer get the step up in basis?

Two similar step up in basis provisions

To answer this question, it is useful to note the history of how the US dealt with taxpayers who expatriate to avoid US taxes.

The old rules

Before 2008, IRC §877 was the controlling law, which imposed special tax rules on taxpayers who “expatriated to avoid tax” for 10 years after expatriation. IRC §877. “Expatriation to avoid tax” is measured through 3 criteria (I will not go into details about them here, but they are the same rules as used for determining covered expatriate status). These special rules include taxes on gains that are otherwise not subject to tax in the hands of a nonresident alien. IRC §§861, 871, 877(d).

To enforce these provisions, the US tax law required expatriates to complete Form 8854 every year for 10 years after expatriation. This requirement applied to any person who expatriated to avoid tax under the old rules.

Under the old rules, a green card holder got a step up in basis in assets he held when he first became a US resident. IRC §877(e)(3)(B).

The new rules

Then, in 2008, Congress replaced the old rules with the current covered expatriate rules, which imposed an exit tax immediately upon expatriation. PL 110-245 §301(a), 122 Stat 168. These rules also gave a green card holder a step up in basis. IRC §877A(h)(2).

Difference between old and new rules

Although both rules allow a green card holder to use a step up in basis on the day he became a US resident to calculate the special anti-expatriation taxes, the two step up in basis provisions are technically different. One step up in basis applies to expatriates who fall under the old rules. The other step up in basis applies to covered expatriates.

Form 8854 is used for both expatriates who fall under the old rules and covered expatriates under the new rules. There are potentially expatriates who fall under the old rules in 2015 who are filing Form 8854, because the old rules applied for 10 years after expatriation.

Given that there are two different step up in basis provisions, it is not surprising if the IRS wants the expatriate to address the step up in basis in different places on Form 8854.

The change is just the IRS fiddling with how information is presented

If you look in the instructions for Form 8854, Balance Sheet, you see the following: “If you are a Part II filer subject to section 877 and you are a former U.S. LTR, it may benefit you to complete column (d).” Form 8854 instructions, 8 (2015).

An expatriate who falls under the old rules (a Part II filer) still completes column (d) and gets his step up in basis. It is a covered expatriate under the new rule (Part IV filer) who does not complete column (d). So does the covered expatriate still get a step up in basis?

Look at Form 8854, Part IV. Line 8 contains a table where you calculate exit tax gains for a covered expatriate. The instructions accompanying line 8 state: “Generally, the cost or other basis in this column cannot be less than the fair market value of the property on the date you first became a U.S. resident.” Form 8854 instructions, 6.

This line in the instruction tells us what happens for a covered expatriate under the new rules: A green card holder who becomes a covered expatriate gets the step up in basis. The step up in basis is incorporated in the calculation of cost or other basis on line 8, but it is not separately stated on the form.

What the IRS really did in 2015 was to place a prominent warning that more or less wants to convey the following message: “For those who expatriated in 2015 and fall under the new rules, do not bother completing this extra column (column (d)) on the balance sheet. It does not apply to you. All it does is make more work for you and us.”

The covered expatriate who gave up his green card in 2015 should ignore column (d) on the balance sheet and fill in his stepped up basis in column (b) on the balance sheet.

Summary

In 2015, the IRS changed Form 8854 slightly to tell the expatriate that he should not complete column (d), FMV on the day he became a US resident, when completing the balance sheet, even if he were a green card holder who expatriated in 2015.

This was not the IRS silently taking away a former green card holder’s ability to step up basis to FMV on the day he became a US resident. It is just the IRS making it more obvious to the expatriate that this column only applies to taxpayers who expatriated under the old rules–before the new ones came into effect in 2008.

Thank you

Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.

Haoshen

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