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The only non-cash basis step up rule (other than death)
Phil Hodgen
Attorney, Principal
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This week's question
This week's question came from a CPA friend, asking about a client of hers. It is a disguised expatriation question. See if you can guess the expatriation question before I answer it:A client [now a U.S. resident] sold his house in China. Since the capital gain is calculated based on the original purchase price, why do some articles say that properties should be appraised before landing to this country? I have been confronted with this question a couple of times. Do you know why?
Short answer
Appraisals of property are a good idea when becoming a U.S. resident, unless you think you will never be covered expatriates sometime in the future.Basis and capital gain generally
The first answer (an answer the client will not like) in my friend's situation is that the entire capital gain from sale of the property in China will be taxable in the United States.Capital gain is taxable for U.S. residents. The taxable amount is the difference between what you invested in the property (called “basis” in tax law jargon) and what you sold the property for.Your investment in the property does not change just because you change your personal status from nonresident of the United States to resident. That's the general rule. As a result, the normal economic calculation (sales price minus expenses of sale minus basis, multiplied by the tax rate) is the U.S. tax result for this individual.Immigrants and basis: one (limited) exception
There is one exception to this general rule – the rule that your basis in property remains unchanged as you go from nonresident to resident status in the United States.The exception is not a blanket exception for all tax purposes – it is an exception only for exit tax purposes.Here is the rule, hot from the oven at Internal Revenue Code Section 877A(h)(2):Solely for purposes of determining any tax imposed by reason of subsection (a), property which was held by an individual on the date the individual first became a resident of the United States (within the meaning of section 7701(b)) shall be treated as having a basis on such date of not less than the fair market value of such property on such date. The preceding sentence shall not apply if the individual elects not to have such sentence apply. Such an election, once made, shall be irrevocable.
Exit tax only, not capital gain tax generally
The first thing to note is that this special rule (creating step-up in basis just because someone changes from nonresident to resident status) applies ONLY to the tax imposed by Section 877A(a) which of course is the exit tax. The special rule does not apply to any other tax.- Thus, normal capital gains tax is imposed on someone who becomes a resident of the United States and later sells property owned when he or she became a resident. Capital gain is computed as the difference between the original purchase price (plus adjustments allowed by U.S. tax law) and the sale price.
- However, if that person expatriates while still owning the property, then capital gain is computed as the difference between fair market value on the first day of residence, and fair market value on the last day of U.S. residence.
When the new basis value is established
The next thing to notice is the moment in time that is important: the first day that the person becomes a resident “as defined in section 7701(b)”.You become a resident “as defined in section 7701(b)” when you meet one of the following three criteria from Internal Revenue Code Section 7701(b)(1)(A):An alien individual shall be treated as a resident of the United States with respect to any calendar year if (and only if) such individual meets the requirements of clause (i), (ii), or (iii):There is a special rule for figuring out the first day of your resident status when you enter the United States on a day other than January 1 (see Internal Revenue Code Section 7701(b)(2)(A)), but I will ignore this because it distracts for the more important point: an immigrant's starting date under any one of these three methods will be the marking date for step up in basis. Green card-triggered resident status (for tax purposes) is only one of these.Some examples of how this would work:(i) Lawfully admitted for permanent residence. Such individual is a lawful permanent resident of the United States at any time during such calendar year.(ii) Substantial presence test. Such individual meets the substantial presence test of paragraph (3).(iii) First year election. Such individual makes the election provided in paragraph (4).
- You started as a green card holder and remain in that status. The exception applies to you, starting from the first day you were a “resident” under the special definitions of Internal Revenue Code Section 7701(b).
- You came to the USA and worked on an H1-B visa, then transitioned to a green card. The exception applies to you, from the first day you became a resident of the USA while holding the H1-B visa status.
- You came to the United States to the United States on an H1-B visa, transitioned to a green card, and eventually became a U.S. citizen.
Interesting trap for the unwary
Interesting “gotcha” opportunity. Let's say in 2002 you were a resident of the United States for two years while working here. You then returned to your home country in 2004. You re-establish resident status in the United States in 2015. What is the step-up in basis date for exit tax purposes – 2002 or 2015? A careful interpretation of the law would say 2002.This is a place where the IRS could give us an answer to solve the problem, but that is not what I dream about at night. Regulations and other official pronouncements from the government are never good news for carbon-based bipedal life forms.This rule is automatic unless you choose otherwise
Here's the interesting thing about the special rule: it applies automatically, and the taxpayer must opt out of it by an election. Again quoting from Internal Revenue Code Section 877A(h)(2):The preceding sentence shall not apply if the individual elects not to have such sentence apply. Such an election, once made, shall be irrevocable.The way you make the election is described in Notice 2009-85, Section 3(D):
Section 877A(h)(2) provides that, solely for purposes of determining the tax imposed by reason of section 877A(a), property that was held by a nonresident alien on the day that individual first became a resident of the United States (within the meaning of section 7701(b)) will be treated as having a basis on such date of not less than the fair market value of such property on such date. A covered expatriate to whom this basis adjustment rule applies may make an irrevocable election, on a property-by-property basis, not to have such rule apply. The election must be made on Form 8854, which must be filed with the covered expatriate's Federal income tax return for the taxable year that includes the day before the expatriation date. See section 8 of this notice for information concerning Form 8854.