The US exit tax, which was signed into law by President George W. Bush in 2008 as part of the Heroes Earnings Assistance and Relief Tax (HEART) Act, is a burdensome financial obstacle to US citizens and long-term permanent residents who plan to expatriate from the US for federal tax purposes.
Not all expatriates are subject to the US exit tax. Only those who are considered covered expatriates must pay an exit tax on their assets when they choose to leave the US permanently.
An individual is considered a covered expatriate if they meet any of the following three criteria:
There are some exceptions to these rules. If certain conditions apply, individuals who are dual citizens from birth or who expatriate before age 18½ may escape the covered expatriate status if they otherwise meet one or both of the first two criteria.
The US exit tax can pose significant financial burdens that may otherwise be reduced or eliminated altogether with careful planning. For this reason many expatriates work with a financial advisor experienced in serving cross-border citizens to strategize appropriate ways to avoid being considered a covered expatriate (or at least minimize the effects of the exit tax). Below are four strategies expatriates and their financial advisors may wish to consider employing to reduce the total amount of tax assessed on the expatriating individual.
If you have a large amount of unrealized gains, it would be wasteful to realize (and pay tax on) all of them, so covered expatriates must be deliberate about how they take advantage of capital gains exemptions strategies. In 2022, covered expatriates are allowed an exclusion of $767,000 in realized gains.
Taxpayers are also allowed an additional capital gains exclusion on primary home sales of up to $250,000 for single filers or $500,000 for married couples filing jointly. Additionally, individuals may wish to take advantage of strategies such as tax-loss harvesting to offset gains up to an additional $3,000 in the same tax year by selling poorly performing assets and deducting those short- or long-term losses against ordinary income. Investors needs to be mindful of the wash sale rules here.
To make the most of capital gains exemptions, individuals can progressively realize capital gains on assets over a number of years prior to expatriating to avoid spiking their capital gains tax rate to a higher level in the year of expatriation. With this strategy, an individual will realize gains on assets progressively while keeping the amount of gain in a given year equal to the exemption for that year. Tax rates for long-term capital gains in 2022 can be seen in the table below:
One strategy to avoid being a covered expatriate is to make progressive gifts to a non-expatriating spouse. To illustrate this strategy, consider the following example:
Mary is a long-term permanent resident of the US who has lived in California with her husband Mark (a US citizen) for the past ten years. Mary’s net worth is $2,500,000 and she is planning to expatriate when the couple moves to her home country of Australia for retirement.
To avoid being considered a covered expatriate, Mary can gift some of her assets to Mark, who is not expatriating, in the year prior to her expatriation date to bring her net worth below the $2,000,000 threshold. If she gifts assets in the amount of $500,000 or more, she will be exempt from the net worth criterion. Assuming she is also exempt from the other two criteria, she would no longer be considered a covered expatriate.
If the situation were reversed and the US citizen spouse was relinquishing while the Permanent Resident was not, the gifting strategy may have to be extended due to the limits on gifting to a non-US citizen spouse. The annual gift exclusion limit for gifts made from a US citizen to a non-US citizen spouse is $164,000 in 2022, up from $159,000 in 2021. Gifts above this amount are permitted but will reduce the donor spouse’s remaining lifetime unified credit (Currently $11.7M USD).
If a nonresident alien spouse elects to be a resident of the US for income tax purposes in the year of transfer under IRC §6013(g), the expatriating spouse may be able to gift funds to a nonresident alien spouse without triggering a gain recognition event. However, other tax consequences should be considered before making this decision.
Alternatively, long-term permanent residents (green card holders) or US citizens may be able to lower their assessable net worth and avoid the covered expatriate status altogether by making a gift to an irrevocable trust (a so-called ‘pre-expatriation’ trust). There is a five-year lookback provision on this strategy, so the transfer must be made at least six years prior to the planned date of expatriation. This strategy can be particularly useful if spousal gifting is not an option or if they have already met the spousal gift exclusion limit for a non-US spouse.
This strategy can be particularly effective for gifts of property where the proposed expatriate has established domicile outside the US. Transfers of non-US-situs and certain US-situs intangible assets are then not subject to US transfer tax and thus avoid US gift tax (including gifts to US donees).
However, tangible US-situs assets are still subject to US transfer tax. It would therefore make sense to use one’s lifetime unified gift exemption to transfer US-situs tangible property to such a trust.
If there’s simply no avoiding the covered expatriate status, individuals can take advantage of other strategies to minimize the effects of the US exit tax. One such strategy involves rolling IRA balances into a US employer-sponsored 401(k) account to prevent the deemed distribution tax on IRA balances all at once when the individual formally expatriates.
With a 401(k), there is a 30% withholding tax due on distributions from the 401(k), which are withheld by the payor. Alternatively, the individual might choose to roll over 401(k) balances if the deemed distribution would result in a lower tax calculation. It’s important to calculate each different scenario to determine the best strategy.
As discussed in a previous blog post, the ‘exit tax’ is not a specific tax per se but the process of classifying one’s global net assets into five different categories and then determining the appropriate taxation on these different categories. The five tax assets classes are:
Some illiquid foreign retirement accounts (e.g., Australian Superannuation) fall under the ineligible deferred compensation category and are taxed at expatriation. Australia provides no liquidity provision (i.e., no way to actually get your money out) to pay this exit tax. Given the illiquid nature of the asset, the expatriating individual should be sure to have sufficient cash on hand to pay the assessed tax.
At the Global Financial Planning Institute, we support fiduciary financial advisors who serve expatriates and repatriates all over the globe. As their financial advisor, you can help them calculate the tax rates on their various assets and consider different scenarios they might use to minimize the effects of the US exit tax.
However, we recognize that this area of financial planning is complex. We can provide the support and education you need to serve your cross-border clients with confidence. To learn more about the GFP Institute and how we can support your practice, visit www.gfp.institute or simply click here to create your free membership account.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual.
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