How to Make Zero Capital Gain Tax When Moving Assets Between Spouses

The net worth test is something that may cause an expatriate to become a covered expatriate. Instead of just having a paperwork problem (Form 8854, specifically), a covered expatriate has a paperwork problem plus a potential tax problem.You become a covered expatriate by satisfying one (or more) of three requirements. Being rich ($2,000,000 or more in personal net worth) is one of those three requirements.Our expatriation cases frequently require some financial engineering to reduce our client's net worth to below $2,000,000 -- in order to avoid covered expatriate status. And that frequently means shifting assets to the soon-to-be expatriate's spouse.This can be done by making gifts from the expatriating spouse to the non-expatriating spouse, or by exchanging assets between the two spouses.

Gifts to Reduce Net Worth

A straight gift from one spouse to the other can be done, of course.If the recipient spouse is a U.S. citizen, the expatriating spouse can use the marital deduction (IRC §2523) to make the gift nontaxable. (As a general principle, gifts from an individual to hise/her U.S. citizen spouse will not be taxable).

ExampleTwo U.S. citizens are married to each other. One will expatriate.They jointly own a house worth $3,000,000. In order to bring his net worth down below $2,000,000, the expatriating spouse makes a gift of his half of the house to his spouse.The gift is not taxable because the gift of 50% of the house qualifies for the marital dedution.

If the recipient spouse is not a U.S. citizen, the giving spouse can use the unified credit to eliminate U.S. gift tax on the gift. The marital deduction is not available.

Exchanges Between Spouses

But sometimes it is not feasible to make an outright gift from one spouse to the other. In some countries, spouses may transfer assets between each other tax-free as long as one does not end up with more assets than the other after the transfer.

ExampleHusband is a U.S. citizen and Wife is not. They live outside the United States.Husband and Wife jointly own a house worth $3,000,000 and a bank account worth $3,000,000.If Husband transfers his half of the house to Wife while Wife transfers her half of the bank account to Husband, there is no taxable gift under their local law. Before and after the transfers, each spouse had $3,000,000 of assets.

But sometimes an imbalance is needed for expatriation purposes. The expatriating spouse needs to reduce net worth below $2,000,000. This causes a taxable event under local law. Usually we see this in countries that have some form of community property law.

ExampleHusband is a U.S. citizen and Wife is not. They live outside the United States.Husband and Wife jointly own a house worth $3,000,000 and a bank account worth $3,000,000.Husband transfers his half of the house (worth $1,500,000) to Wife, while Wife only transfers $400,000 of cash to Husband.Husband's net worth has decreased to $1,900,000 (his original $1,500,000 of cash plus the $400,000 of cash received from Wife).Wife's net worth has increased to $4,100,000 (the half of the house that she owned originally, plus the other half of the house that she received from Husband, plus the $1,100,000 of her own cash that she has left after giving $400,000 to Husband).Because there has been a shift of assets from one spouse to another, making one richer and one poorer, a taxable event has occurred under local law, and the couple will have to pay a tax in their home country.

Why would someone participate in a swap as I described? Usually because the expatriating spouse has sufficient net worth to be a covered expatriate.In that case the expatriating spouse wants to minimize the exit tax by holding assets with little or no built-in capital gain. No capital gain means no exit tax triggered by the "make pretend" sale that covered expatriates are treated as having.This is the mark-to-market rule, and it is easily neutered:

ExampleA covered expatriate owns a single bank account with $3,000,000 cash in it when he expatriates. The mark-to-market rules (IRC §877A(a)) say that he must pretend to sell his dollar bills at fair market value.He acquired his dollars for $1 each, and "sells" them when expatriates for $1, because that is the fair market value of a dollar bill. This means that his capital gain at the time of expatriation is zero, and his exit tax is zero.

Income Tax Issues for Shifting Assets Between Spouses

Transferring assets between spouses can either be:

• a gift (if assets only go one way, with nothing received in return), or
• a sale (if an asset is transferred but something is received in return).

Let's look at the latter situation--my example of jointly owned real estate and cash accounts, in a community property country, where we want to have the expatriate end up with the cash and the non-expatriating spouse end up with the real estate. How do we make this a nontaxable event for U.S. tax purposes?

Assets

All assets are 50/50, by assumption.They have a house worth $3,000,000 and basis of $0, and a bank account with $3,000,000 cash in it.

The Transaction

For reasons known to God and tax advisers like us :-) Husband wants to have all of the cash at expatriation. He’s going to be a covered expatriate no matter what, so by having cash only, there will be no mark-to-market gain and therefore no exit tax payable.Husband and Wife agree:

• Husband gives his half of the house to Wife so he has no ownership of the house at the end of this transaction.
• Wife gives her half of the bank account to Husband so that she owns no cash at the end of this transaction.

Income Tax Analysis

First let’s look at this under the assumption that it was a “sale or exchange” under the income tax rules.When there is a "sale or exchange" you must assume that capital gain is recognized and will be taxed.¹We do not want transfers between spouses to be taxed, however. The assets remain within a single economic unit so imposing capital gain tax on interspousal transfers is silly. Therefore, we have a special rule:

No gain or loss shall be recognized on a transfer of property from an individual to . . . a spouse[.]²

However, this rule does not apply if the recipient spouse is a nonresident alien:

Subsection (a) shall not apply if the spouse . . . of the individual making the transfer is a nonresident alien.³

A nonresident alien is a person who is not a U.S. citizen (therefore "alien") and is not a resident of the United States under the income tax definition of resident.Back to our example: Husband gets Wife's half of the cash, and Wife gets Husband's half of the house.

• If Wife is a U.S. citizen, then the basic rule applies (IRC §1041(a)) and Husband does not get taxed when he transfers his half of the house to Wife in exchange for an equivilent value of cash. Wife is not a "nonresident alien" because she is U.S. citizen.
• If Wife is not a U.S. citizen and is living outside the United States, then the exception to the basic rule (IRC §1041(d)) will prevail. Husband will be treated as selling his half of the house to Wife in exchange for cash. He will pay U.S. capital gain tax on that transfer.

The Section 6013(g) Election

Now the moment of magic.A nonresident alien married to a U.S. citizen or resident can elect to be treated as a resident of the United States for income tax purposes.⁴Assume that Husband and Wife do all of the right paperwork to make that election. They can now file a joint U.S. income tax return..Now we have a U.S. citizen husband (let’s say) and a nonresident alien wife (let’s say) who is taxed as a resident of the United States for income tax purposes (i.e., for chapter 1).

How To Make This Tax-Free

Even if Wife is not a U.S. citizen (i.e., she is a nonresident alien), we can make this asset swap not be taxed to Husband. Let's temporarily make Wife a resident of the United States.

• If Wife is a nonresident alien, then the exchange by Husband of 50% of the house for 50% of the cash will be a taxable sale or exchange because of Section 1041(d).
• We just made Wife a resident of the United States for purposes of U.S. income tax law, by having her make the Section 6013(g) election.
• Therefore Section 1041(d) will not apply.
• And because Section 1041(d)'s exception does not apply, the basic rule of Section 1041(a) ("transfers between spouses will not trigger capital gain tax") will cause a tax-free result.

How to Do It

Make the Section 6013(g) election in one calendar year and move assets around between the two spouses.Then have the expatriating spouse renounce citizenship (or abandon permanent resident status) in the following year.

Gift Tax Analysis

Next, let’s look at the transfer of 50% of the house from Husband to Wife using our gift tax goggles. Is this a gift? Is it taxable?It’s not a gift.A gift is a gratuitous transfer.⁵ The valuation of a gift is the difference between value transferred and consideration received.⁶In this case, there was a transfer of $1,500,000 of real estate and the transferor received $1,500,000 cash in return. This does not look like a gift to me. :-)Even if you call this a gift, you have a valuation of $0 as the amount of the taxable gift, because the value of the gift is the difference between the value of what you gave away, and what you received in return.

Conclusion

If you need to avoid capital gain tax in another country and in the United States for transfers between spouses, consider using the Section 6013(g) election temporarily to eliminate the U.S. capital gain tax problem for an expatriate transferring appreciated assets to a noncitizen spouse.