In 2018 we covered the Heart Act Exit Tax and how it could potentially affect US resident Australian expats. Recently we have seen some of our clients become eligible for Green Cards either through marriage or through the Green Card lottery.

Additionally, we have had an influx of clients who have found out that they are US and Australian dual citizens and have recently become aware of their IRS tax and disclosure requirements.

In brief summary the HEART Act Exit Tax affects US citizens and permanent residents or Green Card holders who are planning to renounce their US citizenship or give back their Green Card.

To trigger the exit tax the IRS must classify you as a covered expatriate. For Green Card holders to be subject to the exit tax they must have been a lawful permanent resident of the Unites States in at least 8 taxable years during a period of 15 taxable years, ending with the taxable year during which the expatriation occurs (when you give back your green card).

To put this simply, if you held your Green Card for a total of 8 years (not sequential) in the 15 period before giving it back, you are subject to the exit tax. There are three tests to determine covered expatriate status, satisfying any one of the three tests will deem you to be a covered expatriate. They are as follows:

  • The tax compliance test
    • You must be able to certify the last 5 years of US tax compliance. You must be up to date with all your federal tax obligations.
    • You must also have filed a Form 8854 (Initial and Annual Expatriation statement) within the deadline for US income tax returns (before June 15) before expatriating from the US. You are able to apply for a 6 month extension to December 15 in certain circumstances.
    • You must have correctly filed and met all federal tax obligations including information returns. This includes things like your FBAR reporting requirements. Should the IRS deem that you have missed information or been “untruthful” then you will fail the tax compliance test and be deemed a covered expatriate.
  • The net worth test
    • You will be considered a covered expatriate if you have $2,000,000 in net worth. For married couples, each spouse determines their net worth separately. Net worth is calculated as your total assets minus your total liabilities. What is included in this assessment is as follows:
      • Assets – Any interests in property that you currently own. An interest in property includes money or other property, regardless of whether it produces any income or gain. The IRS also considers your rights to use property as well as your ownership. Any asset that would incur the US Gift Tax would be assessable under the net worth test. Additionally, the IRS will include any beneficial interest in trusts that you may have.
      • Liabilities – You are able to include your debts as an offset in calculating your net worth.
    • For the purposes of the net worth test, an interest in property would be any assets that would be taxable as a gift if the individual were a resident or citizen of the US. No valuation discounts can be included in your valuation of the assets. The IRS requires your assets to be valued on a “good faith” or fair market basis (no formal appraisals or valuations are required).
  • The tax liability test
    • This test is based on your average federal income tax liability over the prior 5 years before expatriation. If you have an average income tax liability of $165,000 then you are deemed to be a covered expatriate. To put this into perspective, to have a $165,000 federal tax liability you would need to be earning around $550,000 USD pear year (assuming single individual with no tax deductions)
    • The rules regarding married couples filing jointly are less advantageous as they require you to use the full tax liability without a reduction or apportionment. This means that if you and your spouse filed a joint income tax return and the federal income tax liability was $250,000 you would not be able to apportion or half this for each individual. You must use the entire $250,000 in the individuals test which would cause you to be deemed a covered expatriate.

There are some exceptions when it comes to the three tests. These exceptions generally only apply to dual citizens. Regardless of the exceptions, if you fail the certification test you will be a covered expatriate.

If you meet the certification test and fail one or both of the other tests you may be able to use one of the following exceptions and not be deemed a covered expatriate:

  • Dual citizen at birth
    • You became a US citizen at birth, and you became a citizen of another country at birth.
    • On your expatriation date you continue to be a citizen of another country and you continue to be taxed as a resident of that country.
    • On your expatriation date you were not a US resident for 10 of the 15 tax years that end with the year that you expatriated.
  • You relinquish citizenship before age 18 and a half
    • To meet this exception you must do the following:
      • Relinquish your US citizenship before age 18 and a half.
      • You were not a US resident for more than 10 taxable years before renouncing your citizenship.
    • You will be required to meet full IRS tax and disclosure compliance before renouncing your citizenship.

 

If you are deemed to be a covered expatriate how much do you pay in exit taxes

The IRS will assess the fair value of all your assets and property, and then calculate how much capital gains tax you would have to pay if you sold the aforementioned assets today. It is important to note that the assessable capital gain is based on the cost base when you bought the asset and the fair value of the asset when you “sell” it for the sake of the exit tax calculation.

Holding $1,000,000 of cash would incur very little capital gains when compared to holding a property that grew in value by 160% during your years of ownership. The individual will be eligible for a $711,000 exclusion on the mark to market capital gain BUT the individual may not be able to choose how this exclusion is allocated across the assets.

The IRS will apportion the $711,000 exclusions across the whole suite of assets as per their specified formula. This apportionment cannot cause the asset to have their capital gain reduced below $0. The capital gains tax rate applied to any assessable gain can be as high as 23.8% for some assets.

The following example has been taken from the IRS via the following link https://www.irs.gov/pub/irs-pdf/i8854.pdf (page 7).

  Cost Basis Fair Market Value Gain or Loss
Asset A 200,000 2,000,000 1,800,000
Asset B 800,000 1,000,000 200,000
Asset C 800,000 500,000 -300,000
Allocation of the $711,000 exclusion to each asset  
Asset A (1,800,000 / 2,000,000) X 711,000 = 639,900
Asset B (200,000 / 2,000,000) X 711,000 = 71,100
Final amount deemed gain on each asset  
Asset A 1,800,000 – 639,900 = 1,160,100
Asset B 200,000 – 71,100 = 128,900

The IRS then takes this final gain and taxes it at the appropriate rates.

In summary, when giving back your Green Card or renouncing your US citizenship it is important that you understand that you may be subject to the expatriation or exit tax. It is important that you seek legal and tax guidance before giving back your Green Card or renouncing your citizenship to ensure that you do not automatically trigger the exit tax and pay more to the IRS than you should have.

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