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By Elena Hanson
Special to the Financial Independence Hub
In my last blog I talked about expatriation and reasons you may want to give up U.S. citizenship or long-term resident status (i.e., green card). The key reason to expatriate is to end the reporting and tax obligations that come along with the privilege of being a U.S. citizen, especially when you don’t reside there. But before ending your obligations, you may have to pay expatriation tax, also known as exit tax.
Canada has a similar tax, called departure tax, but it’s imposed on your assets when you are no longer willing to reside in Canada.
Who is subject to the exit tax?
Generally, exit tax applies to U.S. citizens who terminate their citizenship and to long-term residents who terminate their status. However, if you are a long-term resident or green card holder who was not a U.S. resident for eight out of the 15 years leading up to expatriation, you are not subject to the exit tax.
In fact, just being a U.S. citizen or long-term resident doesn’t automatically subject you to exit tax upon expatriation. Last time we discussed implications of being deemed a covered expatriate for U.S. tax purposes. You must satisfy one of three tests, which are aimed at identifying people who are high-earning, high net-worth individuals and who are not compliant.
Unfortunately for some, there is a high cost to exiting the U.S. tax system, which can feel like a deterrent to becoming compliant with the Internal Revenue Service (IRS), especially if you haven’t been filing U.S. tax returns up to that point. But it’s always a good idea to stay on the right side of the IRS; it will cost you less in the long run.
What exactly is exit tax?
In 2008, Congress created a mark-to-market tax regime. That means expatriate Americans pay tax on all their worldwide property. In other words, being a covered expatriate means you are covered under Sec. 877A of the Heroes Earnings Assistance and Relief Tax (HEART) Act of 2008, and must pay exit tax upon expatriation on the value of everything you own. The covered expatriate’s property is treated as though it was sold or distributed on the day before expatriation, at its fair market value. Any gains realized from this pretend sale and distribution are considered income for the tax year of the sale.
Can I minimize or avoid exit tax altogether?
You can avoid exit tax by avoiding covered expatriate status. For example, you could be exempt from covered status if you are born in Canada and inherited dual citizenship through at least one U.S. citizen parent who is a U.S. citizen. However, this exemption requires that you spend most of your time in your country of birth and remained compliant with U.S. tax-filing obligations.
This is where many “Accidental Americans” get stuck. It’s hard to be compliant when you don’t know you’re a U.S. citizen, and there can be penalties for non-compliance when you introduce yourself to the IRS. It’s another way of being between a rock and a hard place!
If you find out about your U.S. citizenship much earlier in life and expatriate before the age of 18½, then you avoid covered status. But I can’t imagine having much tax exposure to worry at that age.
Barring these exemptions, it’s best to talk to your professional advisor about possible exit tax strategies. Here are some examples:
- Distributing assets to your spouse. The limit for personal net worth is US$2 million for an individual. However, watch out for Canadian tax implications with this technique.
- If it’s not already too late, leaving the U.S. before meeting the eight out of 15-years residency rule. Bear in mind that years are counted from starting with the year you received a green card. Thus, if you obtained a green card on December 30, 2010, you are a green card holder for all of 2010.
- Timing your expatriation for when the market value of your assets is down.
Obviously, things get much more complicated when you own shares in a private corporation or partnership, or you are party to a trust.
If you are subject to exit tax rules, you face two potential outcomes: 1) A lot of paperwork. 2) A lot of paperwork plus possible tax liability.
But don’t lose heart. There is an exemption from the deemed mark-to-market taxation on the first $737,000 of your worldwide income (threshold for 2020). The balance will be taxed unless you make a deferral election on certain eligible holdings.
Other considerations for covered expatriates include the possibility of paying U.S. exit tax on your Canadian pensions and RRSPs with no corresponding credit in Canada, losing the future benefit of the Canada-U.S. treaty coverage, and the cost of paying an experienced tax practitioner to file this complicated paperwork for you. And even if you are a non-covered expatriate, you still have to submit the relevant forms and filings.
Elena Hanson is founder and managing director of Hanson Crossborder Tax Inc. She is currently doing a podcast series with Darren Coleman, a wealth management adviser, called Two Way Traffic, which is about cross-border tax and financial issues.
