POTENTIAL SETBACKS FOR US EXPATS IN HOUSE REPUBLICAN TAX BILL
Last week, House Republican leaders released their long-awaited tax bill, called the Tax Cuts and Jobs Act. While the GOP bill retains many of the basic principles included in Trump’s previous proposals, there are a couple of changes that could negatively impact expat taxpayers moving forward.
In this blog, we explore these latest changes and analyze their specific impact on U.S. expats.
WHY THE TAX BILL MATTERS FOR EXPATS
A number of news outlets have outlined the general provisions of the Tax Cuts and Jobs Act, and they’ve also described the impact that these provisions will have on particular groups of taxpayers. You can read some of the more comprehensive articles here and here.
The group, however, that has been largely ignored by the media (and by the bill itself, for that matter) is the U.S. expat community. In order to understand the impact of the bill on expat taxpayers, its provisions need to be scrutinized from the unique perspective of the expat who resides abroad but remains bound by the U.S. tax laws.
The particular provisions that have taken a potential turn for the worse in the GOP bill are the following:
(1) THE NET INVESTMENT INCOME TAX – OFF THE CHOPPING BLOCK
One of the bigger surprises in the GOP bill is the retention of the Net Investment Income Tax (NIIT), sometimes called the Obamacare Investment Tax, which Trump has pledged a number of times to repeal.
To briefly explain how the tax works – if an individual has income from investments, the individual may be subject to the 3.8 percent NIIT on the lesser of their net investment income (such as interest, dividends, capital gains, rental and royalty income, among others), or the amount by which their modified adjusted gross income exceeds the statutory threshold amount based on their filing status.
The NIIT was enacted under the 2010 health care legislation in order to fund then President Obama’s health care reform, so one would think that Republicans would be eager to abandon the tax. However, for a time now, according to a Dow Jones news report, Republicans have in fact been considering keeping the tax intact in order to ”ensure there is more funding for subsidies to health-care consumers who acquire insurance.”
So why is the non-repeal of the NIIT significant for expats?
The basic answer is that the foreign tax credit cannot be used to reduce the tax. Consequently, a U.S. expat who otherwise has 100% foreign source income and sufficient foreign tax credits to credit against such income, can still end up paying U.S. federal income taxes by virtue of the NIIT. This would no longer be the case if the tax were repealed. But, for now, it looks as though the NIIT is off the chopping block.
(2) THE GIFT TAX – ALSO OFF THE CHOPPING BLOCK
Ever since Trump introduced the idea of a “death tax” repeal during his presidential campaign, commentators have questioned whether such a repeal would include the gift tax or not. On the one hand, the gift tax serves as a backstop to the estate tax so the two taxes should, in theory, be repealed together. On the other hand, repealing the gift tax could create new opportunities for tax avoidance schemes, so the gift tax should stay even if the estate tax is dropped.
In the GOP bill, Republicans have taken a compromise approach which repeals the estate tax, but only in 6 years’ time (in 2023), and retains the gift tax permanently with certain tax rate bracket modifications to be made over time. The eventual repeal of the estate tax but retention of the gift tax seems to demonstrate that at least in the view of the bill drafters, the gift tax is in fact meant to stand on its own.
So why is this issue particularly relevant for U.S. expats?
The answer is that while the estate tax applies equally to citizens living within and without the United States, and a relatively small number of taxpayers are actually affected by the estate tax in any event, the requirement of gift tax reporting is quite prevalent among expats with non-US spouses, family, or friends (reporting is generally done via the IRS Form 3520). The repeal of the gift tax would have lightened this reporting obligation for expats significantly. But, for now, it looks as though the gift tax and gift tax reporting are off the chopping block.
(3) MODIFICATION OF EXCLUSION FROM GAIN ON SALE OF PRINCIPAL RESIDENCE
The Republican tax reform would modify the current “primary residence exclusion” rule, which allows an individual to exclude gain of up to $250,000 realized from the sale of his or her home ($500,000 if married and filing jointly), provided they meet the “ownership” and “use” tests for 2 out of the 5 years leading up to the sale. Importantly for expats, this exclusion is not limited to homes in the U.S.
Since many foreign jurisdictions offer an exemption on the sale of your residence (thereby creating no foreign tax credits to utilize), home sellers may have a capital gain tax in the U.S., but only to the extent the gain exceeds the primary residence exclusion rule, if available.
The bill would increase the required period of ownership from 2 of the previous 5 years to 5 of the previous 8 years. In addition, the exclusion would be available only once every five years. The exclusion would be subject to phase-out for individuals whose average modified AGI over the year of sale and the two preceding tax years exceeds $250,000 (or $500,000 for joint filers). No phase-out of the exclusion exists under the current rule.
EXPAT TAX PROFESSIONALS KEEPS YOU INFORMED
As we’ve noted in previous blogs, it’s important to keep in mind that each rendering of a tax reform plan will ultimately require the approval of the U.S. Congress, including the Senate, which is a process that is politically charged and may take some time. There is also no guarantee as to which changes will ever come to legislative fruition.
At Expat Tax Professionals, we do pride ourselves on keeping current on all of the important tax changes that may affect your tax filings. We will continue to provide you with the latest tax news affecting your expat tax filing obligations.
