Community property and Form 8854's balance sheet

Hello again from Phil Hodgen.

This is part of our newsletter work.

I received a question about community property:

I am a dual US-[Country X] citizen married to a [Country X] citizen and living in [Country X]. The couple’s joint net worth is above $2,000,000 but below $4,000,000. [Country X] is a community property country. Do you ever apply community property rules when you complete a Form 8854?

Summary

For calculating your net worth during expatriation and the balance sheet on Form 8854, you include only half of the values of assets and liabilities you hold as "community property.

However, there are complications to community property rules that can make it difficult to determine if all your property is community property. Expatriating couples may want to consider using a spousal agreement to transmute all property to community property.

Transmuting property to community property may incur a US gift tax. If you want to avoid paying the gift tax, make the agreement in year 1 and expatriate in year 2. This permits you to use a US citizen’s unified lifetime credit against estate and gift taxes to eliminate or reduce the out of pocket gift tax.

You are using community property rules to avoid becoming a covered expatriate.

The question comes from a person who wants to give up his US citizenship. Under U.S. tax laws, when you lose your US citizenship, you are an expatriate. IRC §877A(g)(2). Expatriates are classified as either “covered expatriate” or “non-covered expatriate.” IRC §877A(g)(1). A number of undesirable tax consequences can follow if you are classified as a covered expatriate. IRC §§877A, 2801.

You are a covered expatriate if your net worth is over $2,000,000 (net worth test).

There are a number of ways you can become a covered expatriate. One way you to become a covered expatriate is if your net worth on the day before expatriation exceeds $2,000,000. IRC §§877A(g)(1)(A), 877(a)(2)(B). This is called meeting the net worth test.

Form 8854 is the return you must complete in your expatriation year. Part V, Schedule A of Form 8854 is a balance sheet, where you are required to list the values of all your assets and liabilities. The IRS uses the balance sheet to determine if you meet the net worth test.

You and your spouse together have a net worth above $2,000,000 but below $4,000,000. Suppose all properties are community property. If you must list the full value of all community property, then you would have a net worth above $2,000,000, making you a covered expatriate.

Each spouse has a 50% interest in community property.

Community property is shorthand for a form of property ownership during marriage. If a married couple owns property as community property, then each spouse has a 50% interest in that property, regardless of whose name is on the property.

For example, if a couple owns a house as community property, then each spouse owns 50% of the house and 50% of the mortgage encumbering the house, even if only one person’s name is on the deed to the property.

Although the most common rule in the USA is separation of property, i.e. no community property, community property is the default rule in most of the world.

You want to use use community property rules to avoid being covered under the net worth test.

Form 8854 is a balance sheet, where you are required to list the values of all your assets and liabilities. The IRS uses the balance sheet to determine if you meet the net worth test.

You and your spouse together have a net worth above $2,000,000 but below $4,000,000. Suppose all properties are community property. If you must list the full value of all community property, then you would have a net worth above $2,000,000, making you a covered expatriate.

If you are allowed to halve the value of property you hold as community property, then you would have a net worth below $2,000,000, because you are halving a value that is below $4,000,000.

You list only your half of the assets and liabilities held as community property.

Net worth test imports gift tax rules.

Notice 2009-85 is the notice where the IRS explains covered expatriate rules. The notice says:

For guidance on determining whether an individual is a covered expatriate by reason of the tax liability test or the net worth test, see Section III of Notice 97-19, 1997-1 C.B. 394. Notice 2009-85, §2.B; 2009-2 C.B. 568.

Notice 97-19 says the following:

For purposes of the net worth test, an individual is considered to own any interest in property that would be taxable as a gift under Chapter 12 of Subtitle B of the Code if the individual were a citizen or resident of the United States who transferred the interest immediately prior to expatriation. For this purpose, the determination of whether a transfer by gift would be taxable under Chapter 12 of Subtitle B of the Code must be determined without regard to sections 2503(b) through (g), 2513, 2522, 2523, and 2524.

[...]

Valuation of interests in property. In determining the values of interests in property for purposes of the net worth test, individuals must use the valuation principles of section 2512 and the regulations thereunder without regard to any prohibitions or restrictions on such interest. Although individuals must use good faith estimates of values, formal appraisals are not required. Notice 97-19, §3; 1997-1 C.B. 394.

In other words, you use gift tax rules to determine the value of an asset for the net worth test. IRC §§2512, 2522-2524.

Your interest in community property is 50% of the value of the property.

Under gift tax rules, the value of a gift is based on how much you own.

When a couple makes a gift of community property, each spouse gives half of the value of the community property. see e.g. Roser vs Commissioner, 2 T.C. 298, 303 (1943). This is because each spouse owns only half of the community property and therefore cannot give away more than they own. Porter vs Commissioner, 49 T.C. 207, 219-220 (1967).

As a corollary, if only one spouse were to make a gift of his half of the community property, then the value of the gift is half of the value of the community property, because he owns only half of the property.

Under gift tax rules, your interest in community property is half the value of the property. The net worth test uses gift tax rules. Therefore, your interest in community property for the net worth test is half the value of the community property. You report only your half of the value of assets and liabilities held as community property on the balance sheet of Form 8854.

Consider using a spousal agreement to ensure the desired result.

Do not assume that community property rules means you automatically divide all property in half.

There are various nuances to community property. Some of the common rules that prevents you from simply dividing all property in half are as follows:

• In some jurisdictions, only property acquired during marriage is community property, while in others, all property is community property, regardless of whether the property is acquired before or during marriage.
• A common, though not universal, exception to community property is that property acquired through gift or inheritance is not community property.
• If a couple moved after marrying, chances are private international law dictates that marital property is determined under the laws of the first country of residence, not the laws of the current country of residence. This is, again, not universal.

These nuances prevent you from simply dividing all property in half for net worth purposes.

A spousal agreement to transmute property to community property achieves the desired outcome.

You can force the desired result in a spousal agreement. In a spousal agreement, the spouses agree amongst themselves that no matter what the law of Country X might say, all assets are community property. Every country I have ever seen (well, except for Indonesia) allows community property rules to be trumped like this. I am going to refer to this as a transmutation agreement, because that is what California calls it. You are transmuting the character of separate property to community, or vice versa.

Plan to make the spousal agreement and expatriate in two years.

Transmuting the character of an asset from separate property to community property under Country X law might trigger a taxable gift from one spouse to the other. If there is an $1,000,000 asset that Country X would consider the expatriate’s separate property, then converting it to community property will be a $500,000 transfer to the expatriate’s spouse.

You are transferring property to a noncitizen spouse. The transfer is not eligible for the unlimited marital deduction. IRC §2523(i)(1). Some of the transfer will be subject to gift tax.

A US citizen gets an unified credit against estate and gift tax. IRC §2505. Normally, this credit permits the citizen to exclude the first $5,430,000 of lifetime taxable gifts and bequests from the gift and estate taxes. IRC §§2505, 2010; Rev. Proc. 2014-61, §3.33; 2014-2 C.B. 860.

The way the unified credit is used against gift tax prevents the expatriate from using the credit in the year of expatriation. Specifically, section 2505 grants the unified credit against gift taxes in the following manner:

[...] there shall be allowed as a credit against the tax imposed by section 2501 for each calendar year an amount equal to--

(1) the applicable credit amount in effect under section 2010(c) which would apply if the donor died as of the end of the calendar year [...] IRC §2505(a)(1).

To get the credit, you look at the credit you would get under section 2010(c) if you died at the end of the calendar year. The section 2010(c) credit is available for US citizens and residents only. IRC §§2010, 2102(b). At the end of the year you expatriate, you are not a US citizen, because you expatriated. You are not a US resident, because you live in Country X. Therefore, you do not get the $5,430,000 unified tax credit.

To take advantage of the unified tax credit, you would have to make the spousal agreement in year 1, thereby making the gift and using your unified credit, then expatriate in year 2.

Disclaimer

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

Send me your questions!

Phil.