Green cards, expatriation, and basis step-up

This is for those green card holders out there who are giving up their permanent resident visa status in the United States, and who have held the green card visa “in at least 8 of the last 15 years.”

If you fit into this category, when you give up your green card you are going to be an “expatriate” for purposes of the exit tax.  You may or may not have to pay an actual tax.  If you are a “covered expatriate” you will have to pay tax.  If you are not a “covered expatriate” you won’t have to pay tax.  Instead, you will just file a large and complex tax return for the year you give up your green card.

This post is not about whether you are a covered expatriate, an expatriate, etc.  I am going to assume that you are a covered expatriate — you are going to pay some tax.  The question is how much.

The “mark-to-market” rules say that everything you own (with some exceptions) is treated as if you (a covered expatriate) sold it on the day before you terminated your green card.  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.”

We know what the sale price will be–the property’s fair market value on the day before you gave up the green card.  But what is your tax basis?  Sale price minus tax basis = capital gain, and that is what you will be taxed on when you terminate your green card.

For someone who is a green card holder (or naturalized citizen, for that matter), tax basis can be one of two things:

• The actual tax basis calculated according to the normal rules (acquisition cost plus capital improvements minus depreciation); or
• The value of the property when you first became a resident of the United States.

Specifically, Section 877A(h)(2) says:

Solely for the purpose 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.

Mandatory; elect out

This is mandatory. The Code says the basis “shall” be not less than the fair market value of the property on that day.

Example

Fred owns publicly traded stock. He bought it for $100,000. When he entered the United States and became a resident, the stock was worth $200,000. Solely for purposes of the exit tax, his tax basis is $200,000. If he is a covered expatriate and terminates his green card and the stock is worth $250,000 on that day, his taxable mark-to-market gain is $50,000.

Example

Fred owns publicly traded stock. He bought it for $100,000. When he entered the United States and became a resident, the stock was worth $50,000. Solely for the purposes of the exit tax, his tax basis is $100,000. His tax basis cannot be less than the fair market value when he becomes a resident, but it can be more. If he is a covered expatriate and he terminates his green card and the stock is worth $250,000 at that time, he has a mark-to-market gain of $150,000.

The Code says Fred can elect out of this treatment. He can elect to have his historical tax basis used for purposes of the exit tax, if he wants to.

How to become a resident

Section 7701(b) lists the ways that a person becomes a U.S. resident. If you satisfy one of these, this step-up in basis rule will apply to you.

• Green card. You are a “lawful permanent resident” of the United States any time during the year. Section 7701(b)(1)(A)(I).
• Too many days. You meet the “substantial presence test” for a calendar year. This means you spent a sufficient number of days in the United States in the current and two prior years to satisfy a mathematical test and you became a resident for income tax purposes.Section 7701(b)(1)(A)(II).
• Special election. You made a special election specified in Section 7701(b)(4) to be a U.S. resident. Section 7701(b)(1)(A)(III).

Why it is fair to citizens, too

Citizens of the United States who expatriate are covered by this rule, too. For someone who entered the United States, became a resident, then a citizen, then expatriated, Section 877A(h)(2) grants a step-up in basis equal to the value on the date that residency commenced. The fact that residency later became citizenship does not matter.

And perversely, the rule applies to citizens born in the United States, too. Someone who is born in the United States will be acquire tax residency immediately upon birth. So that new-born soul is entitled to a step-up in basis on all of the assets that he or she owns at the moment of birth. The Internal Revenue Code is full of justice and equality.

But not U.S. real estate

The IRS, in Notice 2009-85, Section 3(D), has said that they do not intended to allow this step-up in basis rule to apply to U.S. real estate:

The IRS and Treasury Department intend to exercise their regulatory authority to exclude from this step-up-in-basis rule United States real property interests within the meaning of section 897(c) (“USRPIs”) and property used or held for use in connection with the conduct of a trade or business within the United States.

This means that an immigrant who bought U.S. real estate while a nonresident will not be able to step up the basis of that real estate to fair market value effective on the first day of residency.

Example

Fred is a resident and citizen of Ireland.  He buys U.S. real property while he is a nonresident of the United States.  Later becomes a resident of the United States and gets a green card.  Years later, as a covered expatriate, he wants to calculate his mark-to-market gain.  He must use his historical tax basis for the U.S. real property.  He cannot use the fair market value of the U.S. real property on the day that he became a U.S. resident.

Yeah.  The IRS hasn’t written the rules yet.  So what do you do?  Dirty Harry wants to know.