Americans living abroad often face obstacles when opening foreign bank accounts (thanks, FATCA). Many also struggle with the hassle of US tax filings. Renunciation seems a logical solution. But, besides other potential drawbacks, covered expats may have to pay an exit tax when renouncing their US citizenship.
Exit tax does not apply to every American who expatriates. And even when it does apply, there are strategies to minimize its impact. However, these all require longer-term planning.
In this article, we explain the dreaded exit tax, how it is calculated, and how you can optimize your situation before renunciation.
- Who Must Pay US Exit Tax?
- What Is A Covered Expatriate?
- Covered Expat Net Worth Test
- Covered Expat Net Tax Liability Test
- Covered Expat Tax Compliance Test
- Covered Expat Exceptions For (Some) Accidental Americans
- How Is Exit Tax Calculated?
- What Is A “Deemed Disposition” Or A “Deemed Sale”?
- Capital Gains Exemption
- Exit Tax Rules For Specified Tax-Deferred Accounts
- Adjusted Account Basis Upon Renunciation
- Deferred Compensation And Exit Tax
- Non-Grantor Trust Treatment For Exit Tax
- How To Calculate Exit Tax
- Exit Tax Planning – Avoid Being A Covered Expat
- How To Minimize Exit Tax
- Tax Planning Before Expatriation Is Key
Who Must Pay US Exit Tax?
When US citizens give up their citizenship and long-term resident green card holders end their US residency and relinquish their green card, they may have to pay exit tax if they are a “covered expatriate”.
The IRS considers a green card holder to be a long-term resident if they have lived in the US for 8 out of the last 15 years. For the exact definition of long-term resident, read our post about renouncing a US Green Card.
For both US citizens and long-term residents, the same rules apply to determine whether they are a covered expat or not.
What Is A Covered Expatriate?
According to IRS rules, a covered expat meets one of the following criteria:
- Net worth – Value of worldwide assets >2 million
- Net tax liability – Average net income tax of prior 5 years > $190,000 (2023)
- Tax compliance – Not in compliance with federal tax obligations
Let’s look at each criteria in more detail.
Covered Expat Net Worth Test
A US citizen is a covered expat if their net worth at the time of expatriation is $2 million or more. Unlike many other numbers, this amount is not adjusted for inflation.
To determine your net worth, count all your worldwide assets and liabilities. And don’t forget any beneficial interest in trusts. An experienced accountant can help you determine the value of assets and beneficiary shares and calculate your overall net worth.
Keep in mind that the value is as of the day before your expatriation. Consider that the value can increase from the day you start the process to the day or renunciation. If you are just below the covered expat exit tax threshold, apply appropriate planning steps to stay below until the process is completed.
Covered Expat Net Tax Liability Test
Even when their overall net worth is below $2 million, high income earners can be covered expats. They are if their average annual net income tax for the 5 years ending before the date of renunciation exceeds $190,000 (2023). Unlike the net worth number, this threshold is adjusted annually for inflation.
Unfortunately, calculating the average tax liability is not as straight forward as it sounds. Get help from a good tax accountant.
Covered Expat Tax Compliance Test
The most common reason someone is considered a covered expat is that they are not in compliance with federal tax obligations. Luckily, this can often be easily rectified.
To be compliant, you must be up-do-date on your federal taxes. That means you must have filed and paid your federal taxes for the 5 years prior to renouncing. In case you haven’t filed, you can typically catch up with the IRS Streamlined Program if you qualify.
And, very importantly, you must file Form 8854, Initial and Annual Expatriation Statement, timely and with truthful information. Filing Form 8854 late automatically makes you a covered expat, no matter your financial situation. You don’t want to mess this up!
Covered Expat Exceptions For (Some) Accidental Americans
Individuals that became US citizens at birth but have no connection to the US, are sometimes called Accidental Americans. They were either born to a US parent abroad or to NRA parents on US soil, but don’t live in the US. Those Accidental Americans are often unaware of the tax filing requirements that are part of US citizenship, no matter where they live.
The IRS has a relief program that grants an exception to being a covered expatriate if one of the following applies.
- The person became at birth a citizen of the United States and of another country. At the time of expatriation, the individual is still a citizen as well as a tax resident of the other country. And, they have not been a resident of the United States for more than 10 taxable years during the 15 taxable years prior to expatriation.
- The individual relinquishes their US citizenship before the age of 18½ and has not been a resident of the United States for more than 10 taxable years prior to renunciation.
A taxable year here refers to the calendar year.
Now, how does the IRS define “resident of the United States” in this context? The IRS considers a non-US citizen a resident of the United States if they are lawful permanent resident (Green card holder) or meet the Substantial Presence Test.
How Is Exit Tax Calculated?
The exit tax calculation takes multiple things into account and can get quite complex.
Basically, exit tax is calculated based on capital gains of the theoretical sale (“deemed disposition”) of your worldwide assets at the time of renunciation, minus a capital gains exemption. We will explain this in more detail in a moment.
However, some assets would not incur a capital gain when “sold”, for example tax-deferred retirement accounts. Instead, that is considered income and would be taxed at ordinary income tax rates, without any available exemptions. Deferred compensation and trusts also follow special rules.
Let’s look at the details.
What Is A “Deemed Disposition” Or A “Deemed Sale”?
Deemed disposition refers to the theoretical sale of assets. For the exit tax calculation, the IRS acts as if you sell all your assets on the day before renunciation. It doesn’t matter whether you actually sell anything or not. The sale is “deemed”. A deemed disposition, or deemed sale, triggers a taxable event, just like an actual sale would.
Deemed disposition applies to all your worldwide assets that incur a capital gain (or loss) when sold. This includes stock, mutual funds, real estate, crypto, shares in your corporation, and more.
As mentioned earlier, the IRS treats certain assets differently. This includes certain tax-deferred accounts, deferred compensation, and interest in non-grantor trusts. Those follow special rules for the exit tax calculation. More about those in a moment.
Capital Gains Exemption
Many covered expats don’t end up having to pay exit tax, thanks to the capital gains exemption. You can exclude up to $821,000 of capital gains when your renunciation date is in 2023. The exemption amount is adjusted annually for inflation. In 2022, it was $767,000.
But remember that the capital gains exemption only applies to the deemed disposition of applicable assets. Certain retirement accounts and other assets with special treatment don’t get a tax exemption. The categories with special exit tax rules as:
- Specified tax-deferred accounts
- Deferred compensation
- Non-grantor trust interest
Exit Tax Rules For Specified Tax-Deferred Accounts
Specified Tax-Deferred Accounts include individual retirement plans such as IRAs, Roth IRAs, 529 qualified tuition programs, HSAs (health savings accounts).
401k accounts, however, are deferred compensation, not specified tax-deferred accounts, because you are deferring your compensation that you received to grow it in a 401K.
To calculate the exit tax, the IRS treats it as a deemed distribution on the day before expatriation, without early distribution penalty. Distributions are taxed as ordinary income. Note that should you decide to take an actual distribution instead of the deemed distribution, then early distribution penalty rules do apply.
This treatment of certain retirement accounts for the exit tax calculation can result in a significant tax bill for people with sizable retirement savings. Retirement and Health Savings Accounts cannot be gifted, however sometimes being distributed before the renunciation can be a good planning strategy. (We discuss planning opportunities to minimize expatriation tax in a moment.)
Defined benefit pensions, both foreign and US, are also part of the exit tax calculation. Foreign pensions, with a few exceptions, are also subject to exit tax.
Adjusted Account Basis Upon Renunciation
On the upside, the basis of the accounts is adjusted for the deemed distribution. This avoids having to pay taxes on the same money again when you actually receive a distribution later.
As a simplified example, let’s say the original basis (what you deposited into the account) was $100k. At the time of renunciation, the value of the account is $150k, so a covered expat pays exit tax on $50k at income tax rates. The basis for this account adjusts from $100k to $150k on the day of renunciation. In a few years, the account value is $220k and you get a distribution of the entire account (to make this example simple). You’ll have to pay tax on the $70k gain over the new basis.
Deferred Compensation And Exit Tax
Examples of deferred compensation include SEP, Simplified Retirement Accounts, Restricted Stock Units, 401k and 403b plans. As mentioned above, 401k accounts are deferred compensation, not specified tax-deferred accounts.
Deferred compensation falls into two categories with regards to exit tax: Eligible and Ineligible deferred compensation.
Eligible Deferred Compensation
To be eligible, the payor of the deferred compensation must be a US person. In addition, the covered expat must provide Form W8-CE to the payor within 30 days of the expatriation date. From then on, the payor will deduct 30% tax at source on all distributions.
There is no exit tax for eligible deferred compensation. However, you will need to waive any right to request a reduced tax withholding (30%) in the future.
Ineligible Deferred Compensation
Any deferred compensation that does not meet the requirements mentioned above is considered ineligible deferred compensation. Therefore, it is subject to exit tax.
A deemed lump sum distribution of the present value of the accrued benefits is included in the exit tax calculation. Please note that unvested benefits will be treated as vested.
Non-Grantor Trust Treatment For Exit Tax
Interest in a non-grantor trust has its own set of complex rules when it comes to exit tax. Explaining those rules is beyond the scope of this article. As with everything related to calculating the exit tax, it’s best done by an expert. Schedule a consultation with our experts here.
How To Calculate Exit Tax
Generally, you start with listing all assets worldwide and identify if they belong to one of the categories with special exit tax rules that we explained above.
Any assets not included in those categories are deemed sold. So, you pretend that you sell all those assets on the day before renunciation. You then need to recognize the gain or loss.
As mentioned earlier, the first $821,000 of capital gains is exempt from exit tax (2023).
It is typically easy to determine gains or losses for assets like stock or mutual funds, using the cost basis and market price at the time of deemed sale.
For other assets, you must determine the fair market value to calculate the hypothetical gain or loss. An experienced accountant can help you with that.
Exit Tax Planning – Avoid Being A Covered Expat
The first step in tax planning for renunciation is to try to avoid the Covered Expat status. This eliminates the exit tax and related paperwork. To do this, you have a few options, depending on your situation.
The easiest, if it applies to you, is to get back into tax compliance for the prior 5 years. The IRS Streamlined Procedure LINK TO POST provides a way to catch up on back taxes without stiff penalties for not filing earlier. Talk to an accountant to see if you qualify for this.
You could find ways to bring your net worth below $2 million, for example through strategic gifting. However, you cannot gift and renounce in the same year so its very important to do gift tax planning early and carefully.
If you would be a covered expat because of your net tax liability but your taxable income is variable, it can make sense to time the applicable 5 year time window so it doesn’t include the highest tax year.
In some cases, however, no amount of planning can avoid being a covered expat. Still, you can still take steps to minimize the exit tax.
How To Minimize Exit Tax
To minimize the exit tax for covered expats, we need to look at each component that triggers taxation.
When most of your assets are capital assets and subject to capital gains tax, you may not owe much exit tax, thanks to the generous capital gains exemptions.
One strategy for US spouses could be that only one spouse expatriates and the other remains a US citizen. You can then shift assets between spouses. For example, a bank account with cash or cash equivalent wouldn’t yield much capital gains. Real estate, on the other hand, might.
Maybe the long-term family home in the US has significant unrealized gain, while the newly acquired house abroad may not have any. So, the expatriating spouse could own the foreign house, while the spouse that remains a US citizen holds on to the US-based assets. This would also simplify future tax filings.
Keep in mind that those steps cannot be taken in the same year of renunciation. Preferably, you do them a few years before renouncing.
Tax Planning Before Expatriation Is Key
As you can see, there are planning opportunities to avoid being a covered expert. Or to minimize the exit tax when being a covered expat is unavoidable. Every situation is unique. The type and location of your assets can play a major role in devising the best strategy.
Executing the strategy, be it timing the best 5-year window or transferring/gifting assets, takes time.
If you are considering giving up your American citizenship and might be a covered expat, consult with an expert. You might have more options to save exit taxes than you think.
