Last Update: January 2023
There has been a recent upsurge in U.S. expats who are surrendering their U.S. citizenships. In many cases, expatriating individuals no longer want to deal with the seemingly complicated U.S. tax paperwork. In other cases, renouncing citizenship can be an important planning tool for U.S. expats who are trying to reduce the adverse U.S. federal income tax consequences associated with transactions abroad (e.g., real estate transactions that are exempt from tax in a foreign country but are nevertheless subject to U.S. federal income taxation).
Although renouncing one’s U.S. citizenship may sound appealing, it does not come without its own set of tax considerations. In this regard, the Heroes Earnings Assistance and Relief Tax Act of 2008 (the “HEART Act”) dramatically changed the tax consequences associated with renouncing U.S. citizenship in two important ways. The more well-known change was the introduction of a revised exit tax, which applies upon the renunciation of citizenship or the termination of long-term permanent residency by a so-called “covered expatriate.” The second and less well-known change was the introduction of the Section 2801 tax, which applies to gifts and bequests from a covered expatriate, as further described below.
Who is a “Covered Expatriate”?
The tax implications of renunciation depend greatly on whether the individual is classified as a so-called "covered expatriate". In general, you are considered a covered expatriate if any of the following applies:
- Your average annual net income tax for the 5 years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation ($178,000 for 2022).
- Your net worth is $2 million or more on the date of your expatriation or termination of residency; or
- You fail to certify on Form 8854 that you have complied with all U.S. federal tax obligations for the 5 years preceding the date of your expatriation or termination of residency.
The Exit Tax
The exit tax applies both to covered expatriates who relinquish citizenship and to green card holders who relinquish their green cards (including those who abandon their green cards or take a treaty position) if they held their green card for a period of 8 years during the last 15 years.
The exit tax is a tax on the built-in appreciation in the expatriate’s property (such as a house), as if the property had been sold for its fair market value on the day before expatriation.The current maximum capital gains rate is 23.8%, which includes the 20% capital gains tax and the 3.8% net investment income tax.
It is important to note that gain is recognized only to the extent that the deemed gain exceeds in aggregate $600,000, as indexed for inflation. For 2022, the indexed amount is $767,000. Also, the basis of each item of property is adjusted to its fair market value as of the day preceding the expatriation date, for purposes of determining any gain or loss that may be realized subsequently from the actual disposition of the property.
Given the fiction behind the deemed property sale, the IRS is gracious enough to allow the tax bill to be deferred until the underlying property is sold. However, deferring the tax payment will result in the imposition of interest as the need to post a “security” with the IRS as well as the waiver of any rights under an international tax treaty with respect to the deemed income.
Exceptions to the exit tax may apply in the case of dual citizens from birth and certain minors who expatriate before the age of 18½. Each individual's particular circumstances should be analyzed in order to determine if an exception properly applies.
The Section 2801 Tax
Section 2801 of the Internal Revenue Code imposes a tax on US citizens or residents who receive gifts or bequests from covered expatriates who have relinquished their U.S. citizenship. A U.S. recipient of a covered gift or bequest is subject to a tax equal to the value of the covered gift or bequest multiplied by the highest estate tax rate in effect on the date of receipt (the rate is 40% in 2022).
Recognizing that U.S. citizens generally are subject to the U.S. estate tax on their worldwide assets at the time of death, Congress determined that it was appropriate, in the interests of tax equity, to impose the Section 2801 tax on U.S. citizens who receive, from an expatriate, a transfer that would otherwise have escaped U.S. estate and/or gift taxes as a consequence of expatriation.
The IRS has issued proposed regulations that clarify some of the specifics of the Section 2801 tax. Among other things, the new rules confirm that the section 2801 tax is a tax on the recipient of the gift or bequest, not the donor or decedent. The regulations provide that a recipient may submit a request to the IRS, with the consent of the expatriate, to disclose certain return information of the expatriate that may assist the recipient in determining whether the donor or decedent is or was a covered expatriate. Although the IRS may disclose returns and return information upon request, the IRS will not make determinations of covered expatriate status.
The IRS has noted that while Section 2801 is currently effective, the obligation to pay the tax is deferred pending the issuance of final regulations. They have also noted that taxpayers will be given a reasonable period of time after the final regulations are published to comply with Section 2801. The IRS intends to issue the Form 708 (the form being developed to report the Section 2801 tax) once the proposed regulations are published as final regulations.
Estate and Gift Tax Considerations
It is important to note that an individual’s exposure to the U.S. estate tax can be greatly affected by renouncing U.S. citizenship. In general, the estate tax applies to all property owned by a U.S. citizen and to U.S. property owned by a non-U.S. citizen.
While renouncing may shield non-U.S. assets from estate-tax exposure — because only U.S. assets of a non-U.S. citizen are subject to the tax — it can greatly increase the exposure of U.S. assets owned at death, such as U.S. real estate and U.S. stocks. This is because starting with the 2018 year, a U.S. citizen’s shield from the estate tax more than doubled to $10 million (due to inflation, the amount increased to $12.06 million in 2022), but a non-U.S. citizen’s shield remains at $60,000. This often unforeseen tax cost can be significant because of the very high rate of the estate tax: The current maximum rate is 40 percent.
The application of the U.S. gift tax, which more or less acts as the backstop to the estate tax, can also be greatly affected by renouncing U.S. citizenship. For instance, a U.S. citizen can gift an unlimited amount of property to a U.S. citizen spouse without triggering the gift tax, while a gift to a non-U.S. citizen spouse is subject to an annual exclusion limitation amount ($164,000 in 2022). This limitation can significantly curtail a married couple’s ability to give gifts to one another for the purpose of ultimately avoiding the estate tax on U.S. property.
For a further analysis of the hidden tax costs of renouncing U.S. citizenship, please read our popular article featured on CNBC.com on the subject: