This chapter applies to Covered Expatriates only.
Except for three categories of assets, pretend that you sold everything that you own on the day before you expatriated. Apply an exclusion to prevent tax on the first $668,000 of gain, and pay tax on the rest.
Section 1. Assets Marked-To-Market
The exit tax applies to everything a Covered Expatriate owns. The method of calculating tax, however, differs depending on the asset involved. The mark-to-market rules apply to all property of a Covered Expatriate except:
- Any “deferred compensation item;”
- Any “specified tax deferred account;” and
- Any interest in a non-grantor trust.
The exit tax rules for the three exceptions are dealt with in future chapters.
“All property of the expatriate”
“All property of the expatriate” is an idea derived from estate tax principles. If an asset would be included in your gross estate for estate tax purposes, then the mark-to-market rules will be invoked to calculate gain or loss on the day before your expatriation date.
“. . . except”
As noted above, every asset you own is subjected to the mark-to-market rules, except identified categories of assets. They are dealt with in later chapters.
Estate Tax Principles
Pretend that you died on the day before the expatriation date. Force the assumption that you are a citizen or resident of the United States (for estate tax purposes) on that date. What assets would be included in your gross estate?
Those are the assets that are subjected to the mark-to-market rule, after you carve out the three exceptions identified above.
“All property of the expatriate” also includes a class of assets that are not includable in your gross estate for estate tax purposes: beneficial interests in trusts that would not be considered to be part of your estate if you died.
This is a trifle confusing. One of the asset categories that gets special treatment under the exit tax rules is beneficial interests in trusts. How can they simultaneously be subject to the mark-to-market rules plus the special tax rules written for them? The short answer is that the mark-to-market rules apply to grantor trusts, while the special rules apply to nongrantor trusts.
Section 2. Mark-To-Market Sale
We are playing “pretend.” That is what the mark-to-market rules are all about. We pretend that you sold everything that you own on the day before you expatriated. But “pretend” does not sound very serious so the IRS calls it “mark-to-market” instead.
Mark-to-market gain or loss is conceptually simple: the asset is deemed to be sold at fair market value. The difference between the sale price and basis will be capital gain or loss to the Covered Expatriate.
Fair Market Value
The mark-to-market rules behave as a “pretend” sale of assets. Taxable gain or loss is calculated, reported, and taxed according to the normal rules. Basis and holding period will be known, but fair market value will not.
Section 877A gives us some guidance for how to determine fair market value for purposes of the mark-to-market event: use estate tax valuation principles for almost every asset, except for two categories of assets for which the gift tax valuation principles are required.
Insurance Policies: Use Gift Tax Rules
A Covered Expatriate’s interest in a life insurance policy is valued according to gift tax valuation principles under Treas. Reg. Sec. 25.2512-6. A gift is deemed to occur on the day before the expatriation date.
Trust Interests: Use Gift Tax Rules
Similarly, if you have beneficial interests in a trust that must be taxed under the mark-to-market rules, you use the gift tax rules to determine value.
Everything Else: Use Estate Tax Rules
For all assets other than insurance policies and beneficial interests in defective grantor trusts, the mark-to-market rules look to the estate tax rules for establishing fair market value.
The date for valuation is an assumed death for the Covered Expatriate the day before the expatriation date. Assume the Covered Expatriate was a citizen or resident of the United States on that date.
There are some exceptions to the estate tax valuation rules when applied for exit tax purposes. Normally in the estate tax context a decedent’s estate may be valued as of the date of death or six months after the date of death. For the exit tax calculations, you may not use the alternate valuation date. You must use the day before the expatriation date for determining asset value.
Additionally, the exit tax rules do not permit the special valuation rules that apply to farms and farm real estate.
The notorious Chapter 14 rules for family-owned businesses are applied to eliminate any possibility of valuation discounts.
For establishing exit tax mark-to-market value, you ignore the Covered Expatriate’s tax liability that arises as a result of Section 877A.
Determination of Basis
Taxable gain is the difference between the sale price and “basis” (what you paid for the asset). Basis determination is done in the normal fashion for the exit tax.
Step-Up for Immigrants
Green card holders who are Covered Expatriates get a break in the mark-to-market taxation. They may use basis as calculated as fair market value of their assets owned when they became residents of the United States for income tax purposes.
The basis step-up does not apply to U.S. real property interests. The Code is silent on this point but the IRS has announced that it intends to issue regulations to exclude U.S. Real Property Interests from the step-up in basis rule.
Property used or held for use with the conduct of a trade or business within the United States is similarly the target of planned regulations. These, too, will be excluded from the inbound step-up in basis rules.
Gain or Loss
You will calculate gain or loss for each asset that is subjected to the mark-to-market rules by subtracting basis from the “pretend” sale price. You are not finished yet. Next, you apply the one-time exemption from mark-to-market gain to determine your taxable net gain.
Mark-To-Market Gain Exclusion
The mark-to-market rules have a bit of buffer built in. A portion of the mark-to-market gain is not taxed. This helps prevent a tax burden on small-time taxpayers. The exclusion is applied pro rata to all assets that have mark-to-market gain.
The amount of the exclusion was initially set at $600,000. This amount is adjusted annually for inflation. The exclusion amount for expatriations is currently $668,000 for expatriations in 2013.
Applies only to mark-To-Market gain
The exclusion only applies to mark-to-market gain.
The exclusion will therefore not shelter taxable income derived from the acceleration of income recognition from deferred compensation plans, specified tax-deferred accounts, and beneficial interests in nongrantor trusts.
The practical result is painful for a normal person. Long term capital gain might not taxed due to the $668,000 exclusion from capital gain (for expatriations in 2013; indexed for inflation) providing shelter from taxation, while the Covered Expatriate’s IRA balance, for instance, is taxed fully and instantly, without mercy.
Allocation of Exclusion Among Gain Items
The Code is silent on how the exclusion may be used by the taxpayer. The Service, however, is not silent.
Notice 2009-85 tells us that the Covered Expatriate may not choose how to allocate the exclusion. The exclusion amount must be allocated across all assets that have gain taxed under the mark-to-market rules. The mark-to-market tax can be deferred with an appropriate agreement (with security posted) with the IRS. A deferral of tax will not affect the exclusion: it must be applied even to assets for which a deferral agreement is entered into.
The allocation is done as follows:
- Make a list of all of the property owned by the Covered Expatriate which has a built-in gain that is taxed under the mark-to-market rules.
- Get the total mark-to-market gain for all assets.
- Then take the built in gain for a particular property. Create a fraction, the numerator of which is the built-in gain for that property, and the denominator is the total mark-to-market gain.
- Multiply the exclusion amount by that fraction. This is the total exclusion amount that is allocated to the specific asset.
One Exit Tax Exclusion Per Lifetime
Someone who expatriates twice will not get two exclusions. A Covered Expatriate only gets one exclusion per lifetime. Any exclusion amount not used during the first expatriation may be used in the second.
The unused portion is calculated as a fraction. If the first expatriation used up 65% of the exclusion, there is 35% remaining. Later, when the second expatriation occurs, the Covered Expatriate may use 35% of the inflation-adjusted exclusion amount that applies to the second expatriation.
What About Your House?
Consider the Covered Expatriate whose personal residence is subjected to the mark-to-market rules. Fair market value is established by an appraisal. Basis is known. Thus, the amount of capital gain is known.
Section 121 gives a taxpayer a $250,000 exclusion on the sale of a personal residence. Does a Covered Expatriate reduce his or her mark-to-market gain on that asset by $250,000?
Logic would say that the exclusion would apply. Yet it appears that Section 877A’s mark-to-market gain is taken into account “without regard to any other provision of [the Internal Revenue Code].” Quite clearly that seems to defeat an attempt to use Section 121 to eliminate capital gain on the deemed sale of a primary residence under the mark-to-market rules.
A taxpayer who sells his house with the closing date on the expatriation date is taxed differently from a taxpayer whose house is “deemed” sold on that date because of Section 877A.
This, of course, is insane.
Mark-to-market sales may generate losses. Fair market value of an asset might be lower than the amount paid to buy it. Losses are recognized for exit tax purposes, with one exception: wash sales. You cannot do a wash sale (sell a stock and buy it back quickly) to generate a loss.
Reporting Mark-To-Market Gain and Loss
Once you have calculated your taxable gain for mark-to-market taxation and applied the exclusion across all the assets with taxable gain, you are ready to report these numbers on a tax return.
The reportable gains go on the appropriate Forms and Schedules. The plain vanilla Schedule D (for instance) will not provide an easy method for reporting the exclusion amount. You will have to report the correct capital gain amount and detail the reduced capital gain because of the exclusion amount in an attached statement. There is a section on Form 8854 that can be used for this purpose, but if you have more than a handful of assets you will need to create a spreadsheet. The section of Form 8854 is tiny.
Losses similarly are reported on the appropriate Forms and Schedules.
Deferring Mark-To-Market Tax
There is an elaborate set of rules in the Code and in Notice 2009-85. They will allow a Covered Expatriate to defer payment of tax on mark-to-market gain.
However, I would be stunned if someone invokes these deferral rules. Simple arithmetic tells you why. It will be a very, very expensive deferral.
- To defer the tax payment, you must post security for the IRS. This is probably going to be a surety bond. This means the Covered Expatriate will be paying a bond premium to an insurance company every year.
- When the deferred tax is eventually paid, the Covered Expatriate pays the deferred tax and pays interest to the IRS on the tax based on the length of time that the tax payment was deferred.
- The paperwork involved is, let’s just say, nontrivial. In the real world, nontrivial legal work means high lawyer’s fees.
Surety bond premium. Interest. Lawyers’ fees. Bad news.
The out-of-pocket cost items will be high. It will usually be cheaper to sell an asset and simply pay the tax. Only a truly unfortunate Covered Expatriate, backed into a corner, will do look to the deferral rules for salvation.
Basis Adjustments After Mark-To-Market Tax
After the Covered Expatriate has paid mark-to-market tax as required under Section 877A(a), the companion basis adjustment will occur. Assets that had taxable gain recognized for purposes of the mark-to-market rules will have a new basis equal to fair market value as of the date before expatriation. Assets that had a taxable loss recognized will similarly be marked down to reflect a new basis equal to the value on the day before expatriation date.
The exclusion of $668,000 is ignored for this basis adjustment. Even though the gain is not taxed, you receive a mark-to-market basis adjustment to the taxable gain.