Exit Tax for American expats

What is exit tax?

Exit Tax is a tax paid on a percentage of the assets that someone who is renouncing their US citizenship holds at the time that they renounce them.

Exit tax applies to United States expatriates, a term describing people who have renounced their US citizenship and those who have renounced a Green Card that they have held for at least eight years out of the last 15. Letting your US Green Card expire does not necessarily make you an expatriate, as you have to voluntarily renounce your Green Card by filing form I407 and stating that you have no intention of continuing to reside in the United States. If your Green Card simply expires, you still have to file US tax returns. However, US citizens are automatically liable to expat laws surrounding taxation, and as a result are subject to exit tax rules.

How is exit tax calculated?

Exit tax is calculated using the form 8854, which is the expatriation statement that is attached on your final dual status return. This determines the gain on your assets, as well as the taxable amount of this (above the threshold). The percentage of exit tax is different for everyone as it is based on your marginal tax rates. By contacting a tax accountant, they can estimate the amount that you would have to pay in exit tax.

 

How to avoid paying exit tax:

Before you take any steps to expatriate, consult with a tax accountant, as once you are a covered expatriate it is difficult to stop becoming one. A tax accountant will be able to work with your tax returns and reduce the likelihood of you being a covered expatriate, one way of doing this is by moving your assets around and utilising strategic gifting so as to ensure that your net worth is less than $2 million. As a result, it is important to plan ahead in order to reduce the chance of being a covered expatriate in the first place.

However, if not being a covered expatriate is not a viable option, for example your net worth was $3 million at the time of your expatriation, this may not be a bad thing.This is because, as long as the gains, or profit, made on all of your assets within a year is under a threshold of $725,000, then you do not need to pay exit tax on these assets, although you will still have to report them on your personal tax return form. If the profit on your assets is over $725,000, you only have to pay exit tax on the amount that is over the threshold. For example, if you made a profit of $750,000 on your assets, exit tax would only apply to $25,000 of that amount.

However, a retirement fund such as a 401K is a free tax income, as you haven’t paid any tax on this. This means that in the perspective of exit tax, you are unable to place a 401K towards the $725,000 exit tax free amount. This also applies to foreign pensions and IRAs unless you have put the income from these funds on your personal tax return form every year. A final example of assets and revenue streams that are unable to be included in this $725,000 threshold is interest in a grant or a trust, however once again, if you were to place this onto your personal tax return form every year, this would be slightly different. Once again, it is best to contact a tax accountant, as they can advise you as to how you would be able to pay a minimal amount of exit tax.

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What type of expatriate am I?

There are two types of people under expatriate laws, covered expatriates and non-covered expatriates

In order to be a covered expatriate, you have to pass at least one of three tests, the certification test, which certifies that you have filed the form 8854 for the last five years. If you have never filed a tax return or this form, you can correct this using the streamlined tax amnesty program, wherein you can correct previous tax returns for up to five previous years, or submit forms that you haven’t done in the past without incurring the penalty fee that this would normally entail. The certification test essentially states that your tax returns are up to date and correct for the last five years. For certain former citizens, there is another amnesty programme that doesn’t need a social security number or require the payment of any tax liability that you have, provided that it is less than $25,000.

The second test is the tax liability test, you are not considered a covered expatriate if your average net tax liability for the last five years is $168,000 or more. If it is less than this then you are a covered expatriate. This applies to the tax return after non-refundable credits, including foreign tax credits. This means that if an expatriate is paying tax on their income in another country such as the UK, this can reduce the amount of tax that they are paying to the US government due to foreign tax credits. For example, if you were to owe the IRS $10,000, but had paid tax in the UK so had foreign tax credit totalling $9000, then you only actually have $1000 being owed to the IRS and going towards the $168,000 average. 

The third test is the net worth test, which accounts for more expatriates out than the other two tests. You are considered a covered expatriate if at the time of expatriation, your net worth is $2 million or more. Net worth is the total of all of your assets, including property, bank accounts, non liquid assets, trusts and even pension and college funds. When it comes to property, only the portion of the property that you own, rather than the entire value of the property (such as half of a $500,000 house shared with a spouse) is counted towards this total. 

 

Many expatriates living in the UK forget to account for the value of their houses when calculating their net worth, as primary residences aren’t generally taxed when selling, however this is still counted in the person’s net worth. As net worth also includes trusts that are in the name of a person, it is important to include any trusts that another person has set up for you, or that you are the beneficiary of in your net worth calculations, as these can typically equate to large sums of money and as such have a large impact on the overall net worth of an individual. 

If you pass any of the three aforementioned tests, then you are considered to be a covered expatriate and as such are liable to pay exit tax. 

To Summarise:

Exit tax is a tax paid by covered expatriates on the assets that they own. It is paid to the IRS as a part of annual tax returns. In order to be a covered expatriate, you must either have become an expatriate with assets worth over $2 million, had an average net tax liability of less than $168,000 over the last five years, or filed the form 8854 for the last five years. If you think that you may be a covered expatriate, it is wise to consult with a tax accountant as they can advise you on some next steps. 

Contact us at Expat Us Tax to learn more about Exit Tax.