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Summary of the Exit Tax
The exit tax is made up of three main components:
- Pension/Retirement Tax: The value of one’s pension or retirement scheme is taxable either immediately upon expatriation or on a deferred basis.
- Trust Distributions Tax: If the expatriate is a beneficiary of a ‘nongrantor’ trust, distributions to the beneficiary will be subject to a withholding tax on the portion of the distribution that represents ordinary trust income.
- Mark-to-Market Tax: All assets, wherever located, not covered by the previous categories are subject to a mark-to-market tax on unrealized gains as if the expatriate had sold all such property.
The tax rates for these categories range from 20% to 40%. The mark-to-market segment exempts the first $767,000 (adjusted for inflation) of gains from tax. However, paying the exit tax does not end exposure to this scheme. If the expatriate later transfers assets to U.S. citizens or residents, either during life or at death, the recipient must pay a 40% inheritance tax.
Principal Residence Owned By “Covered Expatriate”
If a “covered expatriate” owns a home (in the U.S. or overseas), the question arises about how the exit tax applies upon the deemed sale of that residence, assuming it qualifies as the “principal residence” for purposes of Section 121 of the Code. The exit tax rules are ambiguous and the law is unclear on how the expatriation rules should apply in this situation.
A real sale of the home would qualify for gain exclusion under Section 121, but what about a “pretend” sale?
Significantly, Code Section 877A(a)(2)(A) states: “Notwithstanding any other provision of this title, any gain arising from a [mark-to-market sale] shall be taken into account for the taxable year of the sale.” This means that the mark-to-market rules will take precedence over any other Internal Revenue Code section that might otherwise treat the gain as non-taxable.
The interpretation of Code Section 877A(a)(2)(A) is critical:
One interpretation requires that the taxable gain on the deemed sale of the personal residence be fully taxed, with the only allowable reduction being the exclusion amount allowed by Code Section 877A(a)(3)(A) (for 2022, this is $767,000).
Another interpretation suggests calculating the taxable gain on the deemed sale of worldwide assets, including the personal residence, and then allowing the use of the Section 121 exclusion to reduce that taxable gain by $250,000 ($500,000 if the house is owned jointly and both spouses are expatriating). Any remaining taxable gain is then further reduced by the $767,000 allowed by Code Section 877A(a)(3)(A).
Unfortunately, neither Form 8854, its instructions, nor the only current guidance from the IRS in Notice 2009-85 provide any assistance on this question.
