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Expatriation – What Happens to the “Principal Residence?”

Certain individuals who give up their US citizenship or their green cards are subject to the so-called ”Exit Tax” imposed under Section 877A of the Internal Revenue Code.

Under the so-called “expatriation” tax rules, harsh tax consequences will result if the individual giving up his US citizenship or “long-term” permanent residency (generally, this is an individual who has held a green card for 8 out of the past 15 years) is a so-called “covered expatriate”. Only “covered expatriates” will suffer the onerous tax consequences.

One is a “covered expatriate” if the individual has either a net worth of US$2 million at the time of expatriation; or, if he has a certain average income tax liability over the past 5 years prior to expatriation. One is also automatically treated as a “covered expatriate” if the person fails to notify the IRS that he has expatriated and satisfied all of his tax liabilities for the past five years even if he did not meet the aforementioned dollar thresholds.

This blog post will focus on the Exit Tax and treatment of one’s personal residence upon expatriation. The Exit Tax is what is known as a mark-to-market rule. Under this rule, the individual is subject to tax on the net unrealized gain on all of his world wide assets as if such property were sold for its fair market value on the day before the expatriation date. Thus, the individual must pay US income tax on gain that he is “deemed” to have earned by operation of the Exit Tax rules, when in fact, the individual has not sold anything and is without any cash in hand with regard to the deemed sale.

The Internal Revenue Code at Section 877A(a)(3)(A) permits a covered expatriate to exclude from tax a certain amount of gain that is deemed earned under the mark-to-market rule. The amount is indexed annually for inflation. For 2014, the amount is US$680,000.

Personal Residence

If you own a home, the question arises as to how the Exit Tax will apply upon expatriation. The Exit Tax rules are ambiguous and the law is unclear as to how these rules should apply to the situation of an expatriate who owns his own home.

Significantly, Section 877A(a)(2)(A) provides that “[N]otwithstanding 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.

As discussed in a prior blog post, a taxpayer who sells his personal residence may exclude up to US$250,000 ($500,000 for joint returns) of taxable gain from his or her income under Code Section 121.

How will this apply to the “covered expatriate” who is deemed to sell his personal residence on the day before the expatriation date?

The issue depends on how one interprets Section 877A.

On the one hand, Code Section 877A(a)(2)(A) could be interpreted to require the taxable gain on the deemed sale of the personal residence to be fully taxed, with the only permissible reduction in taxable gain being the exclusion for US$680,000 allowed by Code Section 877A.
On the other hand, the Section 877A mark-to-market rule could be interpreted as an instruction for calculation of the taxable gain on the deemed sale of world-wide assets, including the personal residence, and then permitting the use of the Section 121 exclusion to reduce that taxable gain by US$250,000 (US$500,000 if the house is owned jointly and both spouses are expatriating). Any remaining taxable gain is then further reduced by the US$680,000 allowed by Code Section 877A(a)(3)(A).

It should be noted that Code Section 121(e) provides a denial of the exclusion on the sale or exchange of the personal residence for any expatriate who is subject to the provisions of Code Section 877(a)(1). Code Section 877(a)(1) applies only to certain expatriates who expatriated on or before June 17, 2008. The expatriation rules were very different under the regime in effect at that time. In part, those old rules continued to tax the expatriate on certain items of US-source income for a 10-year period after expatriation. The rules contained in Section 877A are very different. They do away with this 10-year “shadow” period and apply instead, the Exit Tax as well as impose other repercussions on any US individual receiving gifts or bequests from the “covered expatriate”. Arguably the Section 121 exclusion should apply since Congress did not explicitly amend Section 121(e) to prohibit its application when it enacted the newer expatriation regime for those expatriating after June 17, 2008.

Careful Planning is Key

Anyone who is contemplating expatriation must obtain sound tax advice well beforehand. First, it is possible that with careful planning the individual can avoid being treated as a “covered expatriate” in the first place. If this is not possible, a thorough review of all assets should be undertaken. In the case of the principal residence, it may be best to sell this prior to expatriation in order to be able to unequivocally claim the Section 121 exclusion on sale of the residence. If the principal residence is in the US, this is the wisest course of action since the individual will no longer remain in that house and any gain exceeding the amount permitted to be excluded under Section 121 will be taxed whether the residence is sold by the individual while he remains a US person or after he becomes a nonresident alien. If the principal residence is located abroad, other factors will come into play. For example, the individual may not wish to sell that residence because he will continue to live in the country where it is located. The possibility of taxation in the foreign country if the residence is sold must also be considered and carefully examined.

In accordance with Circular 230 Disclosure

Original Source By:  Virginia La Torre Jeker, J.D.


Virginia La Torre Jeker J.D., has been a member of the New York Bar since 1984 and is also admitted to practice before the United States Tax Court. She has 30 years of experience specializing in US and international tax planning as well as international commercial transactions. She has been based in Dubai since 2001; prior to that time she worked in Hong Kong for 15 years as a US tax consultant for international law firms, major banks (including HSBC) international accounting firms (Deloitte) and trust companies. Early in her career she worked in New York with the top-tier international law firm, Willkie Farr & Gallagher.

Virginia is regularly asked to speak at numerous conferences and seminars for various institutes and commercial organizations; publishes a vast array of scholarly works in her area of expertise, been interviewed by CNN and is regularly quoted (or has her articles featured) in local and international publications. She was recently appointed to the Professional Tax Advisory Council, American Citizens Abroad, Geneva, Switzerland. She was a guest lecturer at the University of Hong Kong, LL.M Program (Law Department) and served as an adjunct Business Law professor at the American University of Dubai and at the American University of Sharjah where she also taught the legal / ethical aspects of internet law and internet based transactions.