Hi, it’s Phil. Welcome once again to Expatriation Tuesday, the biweekly newsletter that is all about the tax effects of renouncing U.S. citizenship — or giving up a green card.
This time, let’s talk about why you might want to deliberately be a covered expatriate. For some people, it is a tax-saving strategy.
Success = Basis Step-Up Without Tax
If you do this right, you can, by deliberately being a covered expatriate, harvest some capital gain on your real estate — tax-free. Put another way, you can achieve a step-up in basis of your U.S. assets, tax-free.
Who Should Think About This
The conditions for using this strategy are:
- You do not have big IRA balances or foreign pensions;
- You have U.S. assets (e.g., real estate) that you will continue to own after you renounce U.S. citizenship; and
- Your heirs are not U.S. persons, so gifts and inheritance they receive will not be penalized.
We are going to use the gain exclusion for mark-to-market gain in order to do this. For people giving up citizenship in 2016, this can be as much as $693,000.
Five Tax Problems for Covered Expatriates
I won’t talk about how
you become a covered expatriate. Let’s only focus on what happens if you are
a covered expatriate:
- Your “specified tax-deferred accounts” (IRAs for most people) are treated as distributed in a lump sum to you.
- Some “deferred compensation” (foreign pensions, usually) will be treated as distributed in a lump sum to you.
- Distributions to you from a trust (even a foreign trust) will be taxable.
- Everything else you own is treated as if it is sold, and you are treated as having taxable capital gain.
- If you make gifts or leave inheritances to U.S. persons, they must pay tax on what they receive. The tax rate is the highest gift tax rate in effect.
People who are not covered expatriates do not face any of these problems. The rules simply do not apply to them.
Thus, a person renouncing U.S. citizenship can escape the U.S. tax system with just a paperwork problem either by NOT being a covered expatriate, or by being a covered expatriate for whom the tax cost is zero.
Our job, then, is to see what conditions must be true for someone to be a covered expatriate and have no tax imposed under the exit tax rules.
I am going to skip the discussion of trust distributions. This newsletter is long enough as it is. Instead, I will discuss the other points to show you what should exist (or be absent from) your life to make this an attractive strategy.
IRAs and Pensions
The first problem for covered expatriates is that “specified tax-deferred accounts” are treated as if there was a lump sum distribution at the time of renunciation. Additionally, deferred compensation (pensions, mostly) that are “ineligible” will be treated as if they made a lump sum distribution to you at the time of renunciation.
Let’s focus on IRAs, since this is the most common asset in this category. And let’s assume that you, the potential ex-American, have an IRA worth $200,000.
Someone who is a covered expatriate will have $200,000 of taxable income in the year that he or she renounces U.S. citizenship. But after that, the $200,000 can be distributed tax-free. It makes sense: the $200,000 has already been taxed.
If you are NOT a covered expatriate, you will not have an immediate $200,000 taxable income lump just because of renunciation. Instead, you are taxed on distributions as they are made, in the future. And the U.S. tax treatment of those distributions will depend on whether your home is in in a country with an income tax treaty with the United States, or not.
First, the treaty example. Most income tax treaties say “the country of residence gets to tax a retirement plan distribution”. For instance, someone who is a noncovered expatriate living in the U.K. would receive distributions from an IRA without paying any tax in the United States. The distributions would be fully taxable, however, in the U.K.
Second, the person living in a country without an income tax treaty. In this case, the U.S. will impose income tax on the IRA distributions as they are made to you.
So for a person living in a country without a tax treaty, the question becomes one of timing. Do you deliberately toggle covered expatriate status and get taxed in a giant lump sum now on your IRA? Or do you wait until later, and pay tax as you receive distributions?
There are two extra problems for IRAs (and foreign pensions) over and above the question of “When do I pay income tax on distributions from my IRA?”
The first problem is this: a foreign person (and you will be one of these after you renounce citizenship) who has an IRA in the United States has an asset that is subjected to U.S. estate tax. In my opinion, someone who is expatriating should close out IRAs and move the assets out of the country to avoid estate tax.
The second problem is more sinister. For covered expatriates, there is a potential for double taxation. Here is an example to show you how it works:
You are a covered expatriate and you have a large foreign pension balance because you worked for a company outside the USA for many years. You pay U.S. income tax on this deferred compensation at the time you renounce U.S. citizenship, because you must.
You are 45 years old, so no retirement distributions are made. And you have no legal right to demand a lump sum distribution prior to retirement.
The first problem of course is how you are going to fund a very large tax payment today when you have not received the money from your pension. But let’s not talk about that.
The real problem is when you retire, 20 years later. Now you start to get pension distributions in your home country. Naturally, your home country thinks this is taxable income, and imposes tax on you.
What a surprise! You paid U.S. income tax on your pension benefits when you renounced U.S. citizenship. And you paid home country income tax on your pension benefits again when you retired.
Is there any money left for you?
This problem exists for IRA as well. The problem is a mismatch of timing. Even assuming that the home country agrees that exit tax paid to the United States is eligible for a foreign tax credit in that country, there is a 20 year spread between the time the tax was paid in the USA and the tax was due in the home country.
Anyway. We are talking about covered expatriate status by choice. Take all of these considerations, throw them in a blender, and see what the impact will be for you.
We see people with no foreign pensions and small IRA balances. They are well-positioned to deliberately trigger covered expatriate status, because there are no latent tax problems here.
No U.S. Heirs
The next condition you need in order to deliberately choose covered expatriate status is no U.S. heirs.
When a covered expatriate makes a gift or leaves a bequest at death to a U.S. person, the recipient must pay a tax (at gift tax rates) on whatever was received.1
If your children or grandchildren are U.S. citizens or residents, you do not want to be a covered expatriate. Their inheritances will suffer a grievous tax haircut.
If your heirs are all nonresidents and noncitizens of the United States, then you are in good shape. Covered expatriate status for you will not result in a large tax bill for your heirs.
U.S. Assets (Real Estate, Probably)
The final thing you need — in order to deliberately choose covered expatriate status — is U.S. assets that will be subjected to capital gain tax eventually. Real estate is the classic investment that we see. No matter whether you are a resident or nonresident, when real estate is sold, capital gain tax will be paid.
U.S. stocks are usually tax-free when sold by nonresident investors. You can buy Google stock for $100 and sell for $150, and the $50/share capital gain will be tax free.
So you need this asset, because capital gain is inevitable. If you remain a U.S. citizen, you will pay capital gain tax when you sell. If you renounce U.S. citizenship and are not a covered expatriate, you will pay capital gain tax when you sell. If you renounce U.S. citizenship and are a covered expatriate, you will pay capital gain tax when you renounce your U.S. citizenship.
Basis Step-Up With the Mark-to Market Exclusion
In all three scenarios, capital gain is computed in the same way: sale price minus adjusted basis. The amount of capital gain is the same whether you sell as a citizen, as a noncovered expatriate, or are treated as if you sold as a covered expatriate.
But for the covered expatriate, the first $693,000 of capital gain is not taxed.2
This is what you want to capture as a covered expatriate.
Example Here is an oversimplified example to show you how it works.
You have only one asset: U.S. real estate worth $1,000,000. Your adjusted basis is $400,000. When you sell the property, you will have $600,000 of capital gain.
- If you sell the property while you are a U.S. citizen, the entire $600,000 of capital gain is taxable.
- If you sell the property after renunciation and you are a noncovered expatriate, the entire $600,000 of capital gain is taxable. If you are a covered expatriate, you are treated as if you had $600,000 of capital gain, but none of it is taxable, because the $693,000 exclusion applies.
The nice thing about being a covered expatriate and using the mark-to-market exclusion is that you get a step-up in basis.3
Let’s go back to the example.
You are a covered expatriate, and use the exclusion for step-up in basis of your real estate. Now your tax basis is $1,000,000. If you later sell for $1,000,000, there will be zero capital gain tax.
How Do You Do This?
There are three tests that determine whether you are a covered expatriate or not. You need to deliberately fail one of them.
The first test looks at your average tax liability
for the previous five years. If the average is over $161,000 (for expatriations in 2016)4
then you are a covered expatriate. This test, in my experience, is not something you can work with. Your average is what it is.
The second test looks at your net worth
. Is it above $2 million? If so, you are a covered expatriate. If your net worth is greater than $2 million, leave it there. If your net worth is under $2 million and you can receive a few strategic gifts (e.g., from your spouse) to push you over the $2 million limit, well . . . .
The third test looks at your tax history. For the previous five years, did you file everything you were supposed to? Did you pay all of the tax that you should have paid? This is the certification test
. For most of our clients, we embark on a cleanup exercise to bring people into full compliance. But maybe you will check the “No” box on Form 8854, Part IV, Section A, Line 6, declaring that in fact you have some shortcomings in the “yes I satisfied my tax duties” department. That will make you a covered expatriate. (Shortly after you file your Form 8854, file the remedial paperwork to fix those problems!)
Summary and Disclaimer
In summary, you can achieve a step-up in basis for U.S. situs assets tax-free if you are a covered expatriate. This is not for everyone, and requires careful analysis before action.
In other words, don’t put your head in the lion’s mouth until you know that he will not bite.
More to the point, take this newsletter as an interesting idea, but do not take action until you (or your trusted advisor) have done a metric ton of work to fully understand the consequences of the strategy in your life.
See you in a couple of weeks.