Exit tax for U.S. expats
What is exit tax and who pays it?
Exit tax is a final tax payment for people who are renouncing their US citizenship, and essentially looks at all untaxed assets and creates a final lump sum, that is then paid to the IRS.
Exit tax applies to covered expatriates of the United States, which usually means people who have renounced their US citizenship. US citizens are automatically liable to expat laws surrounding taxation, which includes exit tax. However, it can also refer to those who have renounced a Green Card that they have held in at least eight years. This doesn’t need to be eight consecutive years but must be over a span of the last 15 years. Simply letting your Green Card expire does not make you an expatriate, as although you may now not have as many legal rights in the US, you still must pay your taxes, so the IRS would likely not be made aware of this change. In order to be considered a US expatriate, you have to voluntarily renounce your Green Card using form I407 and stating that you no longer wish to live in the United States.
How to calculate exit tax:
Exit tax is the IRS’s last chance to tax you and is essentially taxed as if you were to sell all your assets on the last day of living in the US. In order to calculate the amount of exit tax that you owe, you need to file the form 8854, which is an expatriation statement that is attached to your final dual status return, and works out the amount of money that you would earn on your assets combined, as well as the amount of this that can be taxed. As the percentage of this amount that you must pay as part of your exit tax is based on your marginal tax rates, it is likely to be different for everyone, currently it cannot be any higher than 23.8%. If you have any difficulty with this, it is a good idea to contact a tax accountant, as they can estimate the amount that you would have to pay in exit tax, as well as help you in the actual process of filing the form 8854.
How to avoid exit tax:
The only expatriates that are paying exit tax are covered expatriates, therefore the best way to avoid paying exit tax is to avoid becoming a covered expatriate in the first place. A tax accountant can help you with this. The main reason that people can end up becoming covered expatriates is due to the net worth test, which is also the criteria that can be changed.
If you do not want to be a covered expatriate, you can hire an accountant to help you to move your money around strategically, using methods such as strategic gifting, which will help you to reduce the value of your assets to below the $2 million threshold.
However, if you are a covered expatriate, you still may not actually end up paying exit tax because, as long as the gains made on all of your assets within a year is under $744,000 (threshold for 2021), then you are not legally required to pay exit tax on this. As usual however, you are still required to put these assets and their attached income on your personal tax return and the form 8854, so that you have still properly reported your income. If the gains on your assets are over the $744,000 threshold, then you will have to pay exit tax on the amount that is over the threshold. For example, if you made $800,000 on these assets in a year, you would only be charged exit tax on $56,000 of this amount.
It is important to note that a retirement fund, including a 401K in the US is a pre-tax income, which means that you haven’t paid any tax on it. Also, you cannot place the value of a retirement fund under the $744,000 exit tax free limit. This will apply to all foreign pensions as well unless you have declared them by putting them on your personal tax return form every year and as such have been paying tax on these funds. In addition to this, beneficial interest in a non-grantor trust falls under the same umbrella in that you are unable to use it as part of this limit. This is why a large proportion of US covered expatriates do end up paying exit tax. As always, it is a good idea to consult a tax accountant, as they will be able to help you to manage your tax returns and ascertain whether or not you need to pay exit tax.
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Types of expatriates:
There are two types of expatriates, covered expatriates and non-covered expatriates. Only covered expatriates are subject to laws surrounding exit tax.
You are a covered expatriate if you meet any one of these three tests: the certification test, the tax liability test and the net worth test.
The certification test confirms that you have complied with all Federal tax obligations for the last five years by filing a Form 8854. If you have not done this, or in any other way have been incorrectly filing your taxes, you have the option to use the streamlined tax amnesty program, which will allow you to rectify this issue without incurring any large penalty fees that may have otherwise been levied at you.
The tax liability test states that you are considered a covered expatriate if your average net tax liability for the last five years is more than $172,000 (threshold for 2021). This amount is only applied to the tax return after non-refundable tax credits. This means that if an expatriate is paying tax in another country such as Australia, they would build up foreign tax credits, so that they are not paying tax to both Australia and the US. This means that these foreign tax credits are then applied to the net tax liability, and will lower it. It is very likely that someone who is looking to become an expatriate will have some foreign tax credits.
The net worth test generally creates more covered expatriates than the other two tests. You are considered a covered expatriate if when you renounce your US citizenship or Green Card you have a net worth of $2 million or greater. The reason that this accounts for more covered expatriates is because your net worth includes everything from your house, savings, illiquid assets such as cars as well as any funds or trusts that may be in your name and even pensions. In terms of property shared between a prospective expatriate and their spouse, only the portion of the property that is owned by the expatriate is put towards this $2 million limit. For example, if a house is split between two spouses and is worth $500,000, then only $250,000 of this would go towards this limit.
Many expatriates living abroad, specifically in the UK don’t account for the value of their houses when calculating their net worth as this would not be taxed under UK law. However, as laws surrounding exit tax are a set of US laws, this does need to be added as part of this $2 million limit. Additionally, if you are a beneficiary of a trust or fund, this money could be included as part of this $2 million, even if you are not the sole beneficiary.
Exit tax is a tax paid by US covered expatriates who want to renounce their US citizenship or Green Card. Not every US expatriate is a covered expatriate, there are three tests to determine whether someone would be considered a covered expatriate or not. You are considered a covered expatriate if your average annual net tax liability for the last five years is more than $172,000, if you failed to certify in a form 8854 that you have complied with your Federal tax obligations in the past five years, or if your net worth is $2 million or more. If you are a covered expatriate you have to pay exit tax and it is a good idea to consult a tax accountant to help you with this.
Contact us at Expat Tax Online to learn more about Exit Tax.
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