Last month, I explained how to determine if you are a covered or non-covered expatriate.
The major difference between covered and non-covered expatriates is that covered expatriates must pay exit tax, and non-covered expatriates do not.
The exit tax applies to everything a covered expatriate owns. The method of calculating tax, however, differs depending on the asset involved.
For most types of assets, the mark-to-market tax applies. To calculate exit tax under the mark-to-market taxation rules, pretend that you sold everything you own on the day before you expatriated. Apply an exclusion to prevent tax on the first $713,000 of gain (for expatriations that occurred in 2018); pay tax on the rest.
There are a few assets – deferred compensation items, specified tax-deferred accounts, and interests in nongrantor trusts – that are excepted from the mark-to-market rules. Those items are still subject to the exit tax, but the method of calculating tax is different from the mark-to-market regime. Those items will be covered in future issues.
In today’s issue, I will talk about the mark-to-market rules – what they cover, how to determine fair market values, how to apply the gain exclusion, and how to utilize mark-to-market losses.
Assets marked to market
The general rule is that “all property of a covered expatriate shall be treated as sold on the day before the expatriation date for its fair market value”.1
“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. As noted above there are three types of assets that are excepted from this rule, but the general idea is that you pretend you sold everything.
Under the estate tax principles
Pretend that you died on the day before your expatriation date. Force the assumption that you are a citizen or resident of the US (for estate tax purposes) on that date. What assets would be included in your gross estate? This guidance comes from IRS Notice 2009-85:2
“For purposes of computing the tax liability under the mark-to-market regime, a covered expatriate is considered to own any interest in property that would be taxable as part of his or her gross estate for Federal estate tax purposes under Chapter 11 of Subtitle B of the Code as if he or she had died on the day before the expatriation date as a citizen or resident of the United States.”
Those are the assets that are subject to the mark-to-market rules, after you carve out the three exceptions identified above.
Plus trust interests
“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. Notice 2009-85 goes on to say:3
“In addition, for this purpose, a covered expatriate also is deemed to own his or her beneficial interest(s) in each trust (or portion of a trust), that would not constitute part of his or her gross estate as described in the preceding sentences.”
This might seem a little 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 and also be excepted from the mark-to-market rules? The short answer is that the mark-to-market rules apply to grantor trusts, while the special rules apply to nongrantor trusts.
We are playing pretend: that is what the mark-to-market rules are all about. You pretend that you sold everything you owned on the day before you expatriated. But “pretend” does not sound very serious so the IRS calls it “mark-to-market” instead. And the exit tax that you pay, after applying the gain exclusion, is in fact very real.
Mark-to-market gain or loss is conceptually simple: the asset is deemed to be sold at fair market value. The difference between fair market value and basis will generate a gain or loss (usually capital) 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 are usually easy enough to figure out, but fair market value can be more tricky, since you are not actually selling your assets.
IRS Notice 2009-85 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.4
“In computing the tax liability under the mark-to-market regime, a covered expatriate must use the fair market value of each interest in property as of the day before the expatriation date in accordance with the valuation principles applicable for purposes of the Federal estate tax, except as otherwise provided in this paragraph.”
Use gift tax rules for valuing life insurance and trust interests
A covered expatriate’s interest in a life insurance policy is valued according to gift tax valuation principles under Treas. Reg. section 25.2512-6. A gift is deemed to occur on the day before the expatriation date.
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.
For everything else, use the estate tax rules
For all assets other than insurance policies and beneficial interests in 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.
Taxable gain is the difference between fair market value and “basis”. Basis is generally whatever you paid for the asset, and where applicable, you make adjustments for capital expenditures and depreciation.
Step-up for immigrants
Green card holders who are covered expatriates get a break in the mark-to-market taxation. They may use a stepped-up basis, calculated as fair market value of the assets they owned when they became residents of the US for income tax purposes.
The basis step-up does not apply to US real property interests. The Code is silent on this point but the IRS announced a while ago that it intends to issue regulations to exclude US 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 US is similarly the target of planned regulations. We expect that these, too, will be excluded from the inbound step-up in basis rules.
Gain or loss
Calculate gain or loss for each asset that is subject to the mark-to-market rules by subtracting basis from the “pretend” sale price. You are not finished yet. Next, you apply a 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 some buffer built in. A portion of the mark-to-market gain is not taxed; the exclusion is applied pro rata to all assets that have mark-to-market gain.
The exclusion was initially set at $600,000, but it is indexed annually for inflation. The exclusion amount for 2018 is $713,000.
The exclusion applies only to mark-to-market gain. That means it does not apply to other gains you report on your tax return, nor does it apply to taxable income from assets excepted from the mark-to-market regime and subject to other rules – deferred compensation, specified tax-deferred accounts, and beneficial interests in nongrantor trusts.
While a $713,000 gain exclusion sounds good, the practical result can still be painful for an average person. Long term capital gain might not be taxed due to the exclusion, while the covered expatriate’s IRA balance, for example, is taxed fully upon expatriation.
How to allocate the exclusion
The Code does not give specific instructions on how to utilize the exclusion, but the IRS gives guidelines in Notice 2009-85.
The exclusion amount must be allocated pro rata across all assets that have gain taxed under the mark-to-market rules, even assets for which you enter into a tax deferral agreement with the IRS. The expatriate may not choose which assets to apply the exclusion to: no preference is allowed for short term capital gains over long term.
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. This requires making two lists, once you calculate your mark-to-market gains and losses: one list of all the “gain” assets, and one list of all the “loss” assets.
- Compute the total mark-to-market gain for all “gain” assets.
- For each asset, 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. The result is the exclusion amount that is allocated to the specific asset.
- Perform this operation for all mark-to-market assets that have built-in gains.
One exclusion per lifetime
Someone who expatriates twice – which is extremely rare – 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 subject 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 “notwithstanding any other provision of [the Internal Revenue Code].”5 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 just before the expatriation date is taxed differently from a taxpayer whose house is “deemed” sold on that date because of section 877A.
This does not make sense. If you are planning to expatriate and also planning to sell your primary residence which is located in the US, we recommend selling the residence before expatriating so you can take advantage of the section 121 exclusion and still utilize the full mark-to-market exclusion for your other assets.
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.
If you have assets with built-in losses, you net those against your gains AFTER you have applied the mark-to-market gain exclusion to the assets with built-in gains.
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. Most assets will go on Schedule D and Form 8949. You will have to report the correct capital gain amount and show the reduction in capital gain because of the exclusion amount in the adjustments column. There is a section on Form 8854 where this information is duplicated, but if you have more than a handful of assets you will need to create an attachment. The section of Form 8854 is tiny.
Losses similarly are reported on the appropriate forms and schedules, and your capital losses that arise from the deemed sale will be netted against post-exclusion capital gains from the deemed sale (as well as all your other capital gains and losses for the year).
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 lawyers’ fees.
Surety bond premium. Interest. Lawyers’ fees. 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 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 day 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.
The exclusion of $713,000 is ignored for this basis adjustment. Even if the entire gain or a portion of the gain is excluded from taxable income, the basis adjustment occurs as if there was no exclusion applied.
Please remember that this post is not intended as legal or tax advice to you; I know nothing about your situation and for the sake of brevity left out many details and important exceptions. Hire a professional to help you.