Expatriation, mark-to-market rules, and personal residences

People who give up their U.S. citizenship or their green card visas are subjected to the exit tax.  This is imposed under Section 877A of the Internal Revenue Code.

The exit tax treats you as having sold all of your assets on the day before you gave up your citizenship or your green card.  If you own your home, this can create problems.  The exit tax laws are ambiguous.  And one of the ambiguities could cost you a lot of money if you own your home.

Mark-to-market rules apply to everything

The mark-to-market rules say that a covered expatriate (someone who meets one of three tests in Section 877A) is treated as selling all of his or her assets at fair market value on the day before giving up citizenship or permanent resident status.

The mark-to-market taxation rules are absolute.  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."

Section 877A(a)(2)(A) says:

“[N]otwithstanding any other provision of this title, any gain arising from [a mark-to-market sale under Section 877A(a)(1)] shall be taken into account for the taxable year of the sale[.]”

This is not difficult.  "Notwithstanding any other provision of this title" means that the mark-to-market rules of Section 877A will prevail over any other rule in Title 26 of the United States Code.  Title 26 is the Internal Revenue Code.  In other words, if there is taxable gain created because of the mark-to-market rules, you ignore all other provisions of the Internal Revenue Code that might tell you to not take the gain "into account" in the year you expatriate.

Covered expatriate and personal residence

This creates a conundrum.  A taxpayer who sells his personal residence may exclude up to $250,000 of taxable gain from income.  This exclusion is found in Section 121 of the Internal Revenue Code.

However, Section 877A(a)(3)(A) gives us very clear rules that say how much mark-to-market gain can be excluded from taxation:  $636,000 for people who expatriate in 2011.  (This is an inflation-adjusted number and the amount for 2011 is found in Revenue Procedure 2010-40.)

So what happens to a covered expatriate?

• Does Section 877A(a)(2)(A) require the taxable gain--as computed under Section 877A--to be fully taxed for a covered expatriate who happens to own her personal residence?  This answer says that the only reduction in taxable gain that will be allowed is the amount allowed in Section 877A.

• Or does Section 877A's mark-to-market rule tell the covered expatriate how to calculate the taxable gain on the "pretend" sale of her personal residence on the day before she expatriates, then allow her to use the Section 121 exclusion to reduce that taxable gain amount by $250,000?  And then the remaining taxable gain is further reduced by the $636,000 amount allowed by Section 877A(a)(3)(A) and Revenue Procedure 2010-40.

The answer is . . . nobody knows.  Srsly.

An example

Alice is a citizen of the United States and Switzerland.  She is a covered expatriate.  She bought her home in Switzerland for $2,000,000, and it is now worth $2,886,000.  Conveniently for this example, Alice owns no other assets.

Alice gives up her U.S. citizenship and calculates her exit tax liability.  She has $886,000 of gain because the mark-to-market rules say she must pretend that she sold her home on the day before she gave up her U.S. citizenship.

If Alice is permitted to use Section 121 to exclude some of the taxable gain on the deemed sale of her home, she will have no tax liabilities for giving up her U.S. citizenship.  Mark-to-market gain is $886,000.  She reduces that by $250,000 for the Section 121 gain exclusion for sale of a primary residence.  She reduces the mark-to-market gain again by $636,000 for the Section 877A(a)(3)(A) exclusion amount, resulting in taxable mark-to-market gain of zero.

If the exit tax rules trump Section 121 and Alice is not permitted to use those rules to exclude gain from the deemed sale of her home, Alice will have $250,000 of taxable gain.  Again, she has $886,000 of mark-to-market gain, but now she can only reduce that gain by the $636,000 exclusion amount of Section 877A(a)(3)(A).  That leaves $250,000 of mark-to-market gain which will be taxable to Alice in the year she expatriates.

What to do?

With that ambiguity, what should Alice do?  The short answer is plan ahead.

An expatriate who is in this position should consider careful liquidation of assets before expatriation in order to take advantage of all possible exclusions and allowances to reduce the taxable gain from the exit tax rules.

For someone whose primary residence is in the United States and who plans to leave, the answer seems clear:  sell the house before expatriating.  This will guarantee that the $250,000 exclusion ($500,000 if both spouses expatriate) will be allowed.  Any excess capital gain would be taxable in any event, so there is no excess tax cost for having closed the sale before expatriating.

For someone like Alice, whose primary residence is in her home country, there would be no personal reason to sell--she plans to remain in Switzerland.  And in fact selling the house could cause taxation in her home country.  This makes tax planning problematic.  As much as I would like to tell you that I have a magic answer here, I don't.  This is something that is solved one client at a time.

I would say that I hope for administrative guidance from the IRS on this.  But let's just say that this falls in the category of "be careful what you wish for."  The IRS clarity cure is frequently worse than the ambiguity disease.