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Exposing the hidden tax costs of renouncing US citizenship

According to Treasury Department figures, 2015 saw yet another record-breaking number of U.S. citizenship renunciations. To that point, the 4,279 expatriations that took place in 2015 surpassed the previous record of 3,415 recorded the year before.

Many experts believe that the main catalyst for this expatriate exodus has been the increasing onus of U.S. tax compliance. The Foreign Account Tax Compliance Act and other tax laws have made U.S. citizens living abroad more keenly aware of their obligation to file annually no matter where they reside and more wary of the increasing costs associated with compliance and the potential penalties associated with non-compliance.

Expat U.S. passport taxes
Jeff Haynes | Getty Images

Renouncing U.S. citizenship under the right circumstances can go a long way toward reducing or eliminating these burdens.

For those considering handing in their U.S. passports for good, it is important, however, to be aware of the potential tax costs associated with renunciation. These costs can be significant but often fly under the radar.

1. The exit tax. Perhaps the most well known of these costs is the so-called exit tax. This tax applies to expatriating individuals if any of the following are true:

  • Your average annual net income tax for the five years ending before the date of expatriation is more than a specified amount that is adjusted for inflation ($160,000 in 2015).
  • Your net worth is $2 million or more on the date of your expatriation.
  • You fail to certify to the Internal Revenue Service that you have complied with all U.S. federal tax obligations for the five years preceding the date of your expatriation.

A "covered expatriate" — i.e., an individual who meets any of the above criteria — is subject to the exit tax, which is a tax on the net unrealized gain in the individual's property (such as a house) as if the property had been sold for its fair market value on the day before the expatriation date.

Net capital gains are currently taxed at the rate of up to 23.8 percent (20 percent maximum capital gains tax plus the 3.8 percent net investment income tax).

2. Cleaning up the past. For the less well-to-do individuals who don't meet the first two criteria for a covered expatriate, avoiding the exit tax comes down to whether they can show the IRS that they've correctly filed their past five U.S. tax returns.

Individuals who haven't been filing or who have made material errors in past filings will need to pay back taxes, if any are due, with interest. Plus, the IRS may impose late fees and penalties for failing to file the required international tax forms.

For example, the penalty for not having filed the FBAR (Report of Foreign Bank and Financial Accounts) or the Form 8938 (the statement of Specified Foreign Financial Assets) can be up to $10,000 per form per year. A delinquent taxpayer should consider entering into an IRS tax amnesty program to clean up the past and minimize penalties.

Renouncers should also consider the costs of hiring a tax preparer to assist with preparing or amending tax returns when calculating the tab for expatriation.

3. Estate-tax considerations. An individual's exposure to the U.S. estate tax, which is a tax on the transfer of your property at death — the "final exit" tax, if you will — 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 a U.S. citizen can currently shield up to $5.45 million of property from the estate tax, while a non-U.S. citizen can only shield $60,000 of U.S. property. 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.

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4. Gift-tax considerations. 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 ($148,000 in 2016). 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. Special rules apply when a "covered expatriate" bequeaths or gifts property to a U.S. citizen.

In the end, renouncing U.S. citizenship has a number of tax pluses and minuses, all of which should be considered before pulling the trigger.

— By Ephraim Moss, licensed international tax attorney and co-founder of Expat Tax Professionals