Hi and welcome again from Phil. This is the every-other-Tuesday Expatriation newsletter. You can stop getting it by clicking the unsubscribe link at the bottom of this email.
James Simango emailed me to follow up on the email I did about gifts by green card holders domiciled outside the United States. (Spoiler alert: they aren’t taxable “gifts” and this makes possible all sorts of pre-expatriation tax planning). He mentioned Section 1041 and specifically the situation of gifts to noncitizen spouses mentioned in Section 1041(d).
James is right. Just because a transfer is not subject to gift tax does not mean you are out of the woods. You need to determine whether the transfer will trigger income tax. This time I will talk about one situation that is fairly common, then tackle Section 1041.
Let’s examine the case of a U.S. green card holder married to a nonresident alien. In order to avoid covered expatriate status, the green card holder intends to give his spouse sufficient assets so that after the gifts the green card holder’s net worth is under $2,000,000. This makes the net worth test problem go away. IRC §§ 877(a)(2)(B), 877A(g)(1)(A).
The family home is worth $5,000,000 and has a mortgage of $500,000. It is owned equally by our green card holder and his spouse. Our green card holder decides to give the home to his spouse, and after the gift his net worth is comfortably below $2,000,000, so he can abandon his green card without being a covered expatriate.
Here is the problem. When you give away property that has a debt tied to it (like real estate with a mortgage on it) the U.S. tax system treats this event as a part-sale and part-gift.
When you dispose of property, the tax system tries to figure out if you have any capital gain on the disposition. First, it looks for property (like money) that you received in exchange for the property you gave away. In the example we are looking at, there is none. Our green card holder gave the house to his wife, and received nothing in return.
The tax system says that if you dispose of property and in the process you are no longer required to pay a debt, then this is the same as receiving money. It makes sense. If you are not required to pay a debt, you are “richer” by the amount of the debt you are no longer required to pay.
So, for instance, if you give away a property with a mortgage on it, you must look to see if you are forever free of that debt. If the bank cannot come after you personally, you are “richer” and you have received income in the amount of the mortgage that you no longer have to pay.
This means that when you give the house to your wife, you may be treated as having been paid $250,000 by your wife, because she took over your half of the mortgage. And that $250,000 is taxable income to you.
Technically, the tax system looks at your gift as a bargain sale. Estate of Levine v. Commissioner, 634 F.2d 12 (1980). The transfer is treated as a sale up to the amount of debt that the transferor is no longer required to pay. And the transfer is treated as a gift for the rest of the value of the property transferred.
The gift tax results discussed last time (“a green card holder domiciled abroad is not covered by the U.S. gift tax rules”) cover the extra part of the value of the house that our green card gave away. But the income tax rules will want to impose capital gain tax as if he received a $250,000 payment from his noncitizen wife.
Usually, Section 1041 rides to the rescue. It is a trump card for transfers of property between spouses, making them non-taxable for capital gain tax purposes. Usually, then, we do not think twice when one spouse gives something to another spouse. There is no gift tax on such a transfer, and there is no capital gain tax, either.
Except for transfers to noncitizen spouses. When a U.S. taxpayer (like our green card) makes a transfer to a noncitizen spouse, the general rule (“that transfer will not trigger capital gain tax”) does not apply, and it is very possible indeed for the transfer to trigger capital gain tax. IRC § 1041(d).
In the example that I gave (gift of encumbered property to a noncitizen spouse), it is very possible indeed for there to be capital gain tax, even though there is no gift tax. And this is what James mentioned in his email – the problem of Section 1041(d) in the context of gifts by green card holders abroad.
Don’t make gifts willy-nilly before understanding the gift tax and income tax rules. But when you examine the situation, look at the tax laws that apply, and also look at the facts.
It is entirely likely that the giving away the house with the mortgage on it will not relieve you of (theoretical) personal liability for the debt. Perhaps the terms of the loan say “Husband and Wife are the borrowers, and it doesn’t matter what they do with the property and it doesn’t matter what they do as between themselves. They are both personally liable to pay the mortgage.”
In that case, the husband would give away the house but retain the liability for the debt. There would be no relief from indebtedness, and therefore no bargain sale. The green card holder would not have a $250,000 “payment” from his wife on which the IRS would seek to impose capital gain tax.
The point of this missive is:
James raises a host of questions in his email that I am not going to cover here. There isn’t enough time. He talks about carryover basis for the recipient spouse. There is also the non-trivial question of whether there is a gift tax in the country where they live.
And of course there are a metric tons of traps for the wary and unwary. So move carefully.
That’s it for this edition. See you in a couple of weeks, and remember the standard disclaimer:
This is not tax advice. It’s probably wrong, is absolutely incomplete, and your humble scribe is typing in the dark outside at Cathedral High School in Chinatown while his daughter is playing soccer. It is a well-known fact that darkness diminishes mental acuity. (“You get dumb in the dark”). Find someone, tell your story, and get concrete advice tailored to your situation.
All the best,