Are you a green card holder planning to go back to your home country? Are you a U.S. citizen planning to retire in a foreign country? Are you a dual-citizen who do not want to be subject to worldwide taxation anymore? If you are considering giving up your U.S. citizenship or green card, think twice before you pull the trigger. Before you do so, you should be aware of many things and plan ahead. This week, I will cover one of them - the expatriation tax (more commonly known as the exit tax).
Who will be subject to the exit tax
There are two questions you need to ask yourself.
1. Am I a U.S. citizen or a long-term resident?
The expatriation tax rule only applies to U.S. citizens or long-term residents. If you are neither of the two, you don't have to worry about the exit tax.
A long-term resident is defined as a lawful permanent resident in at least 8 of the 15 years period ending with the expatriation year. For example, if you got a green card on 12/31/2011 and plan to expatriate in 2018, you will be treated as a long-term resident under the expatriation tax law.
Planning tips: As a green card holder, you do not need to count years if you make a valid treaty election to be treated as a nonresident alien for that entire calendar year. It is always worth checking whether you could make the treaty election this year or even years to avoid being treated as a long-term resident.
2. Am I a "Covered Expatriate"?
If you are either a U.S. citizen or a long-term resident, expatriate on or after 06/17/2008 (check any of the three tests directly from the IRS website below), you are a "covered expatriate" who will be subject to the exit tax.
- The Tax Liability Test - "Your average annual net income tax for the 5 years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation" ($165,000 for 2018).
Planning tips: This is an income tax test, not an income test. You could use most of the deductions, exemptions, credits, and even the foreign earned income exclusion to lower your income tax liability. If your tax status is married filing jointly, you have to use the total income tax liability amount on your joint tax return even only one of you are expatriating. It could be better to use married filing separately status ahead of time to reduce the five-year average.
- The Net Worth Test - "Your net worth is $2 million or more on the date of your expatriation or termination of residency."
Planning tips: You could take advantage of the annual gift exclusion amount ($15,000 for 2018) and the applicable exclusion amount ($11,200,000 for 2018) to transfer your assets to anyone, including a specifically designed trust, at least one calendar year before the year you expatriate. Or you could give your assets to your U.S. citizen spouse free of gift taxes due to the unlimited marital deduction. Please be aware that there are certain limitations on gifting assets to a noncitizen spouse which you could learn more about it from my previous blog here. Sometimes, it makes sense to lower your net worth by selling some assets and paying taxes before expatriate.
- The Certification Test - You fail to certify on Form 8854 that you have complied with all U.S. federal tax obligations for the 5 years preceding the date of your expatriation or termination of residency.
Planning tips: Unfortunately, I don't have any tips for you on this one. Before you check the box on Form 8854, I recommend you fix everything, including all the foreign assets reporting requirements I talked about in my previous post here.
If you are qualified for one of the two exceptions below and also satisfy the certification test mentioned above, you are not a "covered expatriate," and you are not subject to the exit tax.
- You are a U.S. citizen and a citizen of another country at birth. You remain as a citizen of and taxed as a resident of that other country and have been a resident of the United States for not more than 10 of the last 15 tax years.
- You are under age 18 1/2 on the date you expatriate and have been a U.S. resident for not more than 10 years.
How bad is the exit tax?
In general, all the property around the world of a covered expatriate will be taxed as if they were sold for its fair market value on the day before the expatriation date. This is also often referred to "mark-to-market" or "deemed sale".
Certain gifts and assets you transferred three years before expatriation may also be subject to the deemed disposition tax due to a specific rule.
Yet the capital gains amount that would otherwise be includible in gross income because of the deemed sale rule is reduced (but not to below zero) by $713,000 for 2018 (indexed for inflation).
Three types of assets below are exceptions to the deemed sales rule and are subject to their own special tax treatment.
- Any deferred compensation item
Eligible deferred compensation items including 401(k)s will only be taxed upon distribution and generally subject to 30% withholding tax.
Ineligible deferred compensation items will be taxed as a deemed present value lump sum distribution.
- Any specified tax-deferred account
This type of asset, including but not limited to Traditional and Roth IRAs, will be taxed as a deemed lump sum distribution on the day before expatriation. The only special treatment here is that you don't have to pay any early distribution penalties if any.
- Any interest in a non-grantor trust
This category will be treated similarly to eligible deferred compensation items mentioned above. In general, 30% taxes will be withheld automatically when distributions are paid out.
Planning tips: You can make an irrevocable election to defer the deemed disposition tax on certain assets until it is actually sold, providing you meet all the requirements from the instructions for Form 8854. Or you could also consider rollover your IRAs back to your retirement plan at work like a 401(k) if allowed to avoid the deemed sale rule. Even though I cannot find any rules that can specifically prevent you from using the home sale exclusion once you expatriate, to be safe, I recommend you consider taking advantage of it while you 100% can.
In summary, if you think you are potentially subject to the exit tax in the future, the best strategy is always trying to avoid being treated as a "covered expatriate" or even a long-term resident in the first place. And of course, the exit tax is only one of the many factors you need to consider before you decide to give up or not to give up your U.S. citizenship or green card. I strongly recommend you consult with a qualified tax and legal professional and do some pre-expatriation planning based on your specific situation.