We often mention that covered expatriates, who are subject to a deemed sale of all their worldwide assets (with a few exceptions), are permitted to exclude the first $700,000 or so of gains that arise from the deemed sale.
For someone hiring us to prepare their tax return, that is typically all they really want to know – “my exit tax is lower because I get to exclude some of this pretend income”.
It is rare that we talk about how to apply the gain exclusion, because that is the behind-the-scenes work that we do for our clients when preparing their tax returns.
Today’s topic will cover just that: How the gain exclusion is applied to all the assets you are pretending you sold.
What “covered expatriate” means
An expatriate is either a citizen who terminates his citizenship, or a green card holder who has had the green card for a long enough time 1
and terminates the green card.
A covered expatriate is an expatriate who meets any one of three financial tests:2
- Net tax liability test – If your average net US tax liability for the five years before expatriation is more than approximately $160,000 (indexed annually for inflation), you are a covered expatriate.
- Net worth test – If your personal net worth is $2,000,000 or greater when you expatriate, you are a covered expatriate.
- Certification test – If you cannot certify under penalties of perjury that your tax returns for the 5 years before expatriation are correct, complete, and all your tax is paid, you are a covered expatriate.
I will not talk about how to apply these tests in this publication; that is a topic (or series of topics) for another time. It is sufficient to know that if you are expatriating and you meet any one of these tests, you will be a covered expatriate.
Covered expatriates pretend they sold all their stuff
A special rule applies to covered expatriates:3
All property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value.
This is where you have to play pretend. You still have all your stuff, but for your tax return, you must pretend you sold all your stuff. You pay tax on the pretend gains and can deduct losses according to the normal rules. The tax you pay on the pretend sale of all your assets is known as the exit tax.
There are a few assets that are exceptions to this rule. You do not have to pretend you sold them; other rules apply to these assets instead. The assets not subject to the pretend sale are deferred compensation items, specified tax deferred accounts, and interests in nongrantor trusts.4
I will not discuss what those terms mean or what special rules apply to them here. I will focus instead on assets that are subject to the deemed sale.
Gain exclusion for deemed sale assets
It is generally bad to be a covered expatriate, because you must pay tax as if you sold all your assets without receiving the cash you would get had you actually sold your assets. There is also the issue of having to pay US tax on the sale of your foreign assets, but without the benefit of a foreign tax credit to help offset the US tax.
To lessen this burden, you can apply an exclusion to reduce the gains on which you have to pay tax.5
The gain exclusion was $600,000 when the law was first enacted. That amount is indexed for inflation, so it increases each year. If you expatriate in 2018, you are allowed to exclude the first $713,000 of gains from the pretend sale of your worldwide assets.
Note that the exclusion does not apply to gains that arise from regular transfers or sales – it applies only to the assets that you have to pretend you sold because you are a covered expatriate. You can use it to reduce your exit tax, but not your regular income tax.
How to apply the exclusion
The Internal Revenue Code does not explain how to apply the gain exclusion against your deemed sale gains. The rules for this are instead found in Notice 2009-85.
The instructions are quite explicit:6
Specifically, the exclusion amount must first be allocated pro-rata to each item of built-in gain property (“gain asset”) by multiplying the exclusion amount by the ratio of the built-in gain with respect to each gain asset over the total built-in gain of all gain assets. The exclusion amount allocated to each gain asset may not exceed the amount of that asset’s built-in gain. If the total section 877A(a) gain of all the gain assets is less than the exclusion amount, then the exclusion
amount that can be allocated to the gain assets will be limited to the total section 877A(a) gain.
From this blurb, you can extract a set of instructions. (There are also some really helpful examples in Notice 2009-85 that demonstrate how this works.)
1. Separate assets with built-in gains from assets with built-in losses
The exclusion is applied to “gain assets” only – assets that, if you sold them, would generate gains rather than losses.
This means your first step is to make a list of all your deemed sale assets, their fair market values as of the day before your expatriation date, and their bases as of that same date. Hint: If you have a bunch of stocks that you hold in a single brokerage account, you must do this separately for each stock – you cannot consider the account a single asset.
Compute gain or loss by subtracting basis from fair market value for each asset. If the result is a positive number, it is a gain. Negative, loss.
Next, create two separate groups: assets with built-in gains, and assets with built-in losses.
The assets with built-in losses we will set aside until a later step. It is the assets with built-in gains that we are now concerned with.
2. Allocate the exclusion pro rata to all the gain assets.
Now that you know what the gain assets are, you must allocate the exclusion to all the assets.
To do this, you start by computing a ratio for each asset: the ratio of the gain for that asset over the total built-in gains of all gain assets. It is pretty easy to do this in Excel using formulas, once you have all the gain amounts computed.
Lastly, you multiply the ratio you calculated by the total exclusion amount for the year. That will give you the amount of the exclusion allocable to the gain for that asset.
3. Be mindful of limitations
If your total built-in gains for deemed sale assets are less than the total gain exclusion amount, you will not have to pay exit tax on your gains because they will be fully excluded.
Remember, however, that the exclusion you can take is limited to the amount of the built-in gains you have on deemed sale assets. In other words, you do not get to take a loss for the exclusion that is in excess of your total gains from the deemed sale, and you do not get to apply the exclusion to real dispositions or transfers that you may need to report for that tax year.
4. Report the gains and the exclusion on your tax return
Your last step is to report the gains and the exclusion you allocated to them on your tax return. Notice 2009-85 has instructions for this, too:7
After allocating the appropriate amount of the exclusion amount among the gain assets, the covered expatriate must report gains and losses on the appropriate Schedules and Forms depending upon the character of each asset. Losses may be taken into account only to the extent permitted by the Code, except that the wash sale rules of section 1091 do not apply.
You report the gains according to the character of each asset. For assets that would normally get reported on Schedule D and Form 8949, you report the deemed sale on Schedule D and Form 8949, use the adjustment column to show the exclusion, and the net gain flows to your Form 1040. For passive foreign investment companies, use Form 8621 to report the gains. For business assets, use Form 4797.
These instructions also tell you what to do with the losses that you had set aside in Step 1 above: those also get recognized according to the normal rules, with the exception that the wash sale rules do not apply.
A simple example, using three assets
Let us take a quick look at how the allocation of the gain exclusion would work, using an example.
Pretend that you are expatriating in 2018, and you have exactly three assets subject to the exit tax. Two of them have $500,000 each of built-in gain. One has $500,000 of built-in loss. All are capital assets that get reported on Schedule D.
The gain exclusion for 2018 is $713,000.
First separate out the gain assets from the loss assets. Your total gains are $1,000,000.
You then compute the ratio of the gain for each asset over the total gain. In our example each asset will have the ratio of .5, because the gain is $500,000 divided by total gains of $1,000,000.
Next, multiply the ratio for each asset by the total exclusion amount. $713,000 x .5 = $356,500. That is the amount of the gain exclusion allocated to each gain asset.
Now, you know the amount of gain that you have after applying the exclusion: ($500,000 – $356,500) x 2 = $287,000.
You end up with $287,000 of total capital gains. Remember you also had $500,000 of capital losses. The result is a net capital loss of $213,000 from the deemed sale. If these are the only dispositions of capital assets that you report on your tax return, you will have to carry some losses forward to future years.
If you have high built-in gains in your assets, you will not end up with such a nice tax result. More often than not, the tax returns I prepare for covered expatriates show net taxable gains and exit tax to pay.
But this example is interesting, in that it demonstrates that the gain exclusion is applied in a favorable way: rather than applying the exclusion after deemed sale gains and losses are netted, the exclusion is first applied to gains only, and then post-exclusion gains and losses are separately reported. If you are dealing with a pool of only capital assets, that means you net post-exclusion gains against losses.