Retiring abroad? Turning in your passport can be taxing

  • Green card holders returning to their home country, dual citizens avoiding worldwide taxation or U.S. citizens retiring in a foreign country may be subject to the expatriation tax.
  • Citizens and residents moving abroad who meet one of three tests — for net worth, tax liability or certification — are covered expatriates who are subject to the tax.
  • All property of a covered expatriate will be taxed as if it had been sold for fair market value on the day before the expatriation date.

Before you consider giving up your U.S. citizenship or green card, make sure you plan for the expatriation tax, more commonly known as the exit tax. If you are a green card holder planning on going back to your home country, a dual citizen who doesn't want to be subject to worldwide taxation (taxation in more than one country), or a U.S. citizen planning on retiring in a foreign country, you may be subject to the expatriation tax.

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US citizen or long-term resident?

The expatriation tax rule applies only to U.S. citizens or long-term residents. If you are neither of the two, you don't have to worry about the exit tax. A long-term resident is defined as a lawful permanent resident during at least eight of the 15 years before the expatriation year. For example, if you got a green card on December 31, 2010, and plan to expatriate in 2018, you will be treated as a long-term resident under the expatriation tax law.

As a green card holder, you do not need to count the years you make a valid treaty election to be treated as a nonresident alien for the entire calendar year. It is always worth checking whether you could make a treaty election to avoid being treated as a long-term resident.

Am I a covered expatriate?

If you are either a U.S. citizen or a long-term resident, you expatriated on or after June 17, 2008, and any of the three stipulations below apply to you, you are a "covered expatriate" and will be subject to the exit tax.

1. The tax liability test. Your average annual net income tax for the five years ending before the date of expatriation or termination of residency is more than a specified amount adjusted for inflation ($165,000 for 2018).

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This is an income-tax test, not an income test, which means you can use deductions, exemptions, credits and even the foreign-earned income exclusion to lower your income-tax liability and your chances for having to pay the expatriation tax. If your tax status is married filing jointly, you have to use the total tax liability amount on your joint tax return, even if only one of you is expatriating. It might be better to use the married filing separately status before you plan to expatriate to reduce your five-year income-tax average.

2. The net worth test. Your net worth is $2 million or more on the date of your expatriation or termination of residency.

You can take advantage of the annual gift exclusion amount ($15,000 for 2018) and the applicable exclusion amount ($11,200,000 for 2018) to transfer your assets to anyone, including a specifically designed trust, at least one calendar year before the year you expatriate. Or you could give your assets to your spouse — if he or she is a U.S. citizen — free of gift taxes, due to the unlimited marital deduction. There are certain limitations on gifting assets to a non-citizen spouse. Sometimes it makes sense to lower your net worth by selling some assets and paying taxes before you expatriate.

3. The certification test. You fail to certify on Form 8854 that you have complied with all U.S. federal tax obligations for the five years preceding the date of your expatriation or termination of residency. Before you check the box on Form 8854, I recommend you fix everything, including all the foreign assets reporting requirements.

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If you are qualified for one of the two exceptions below and also satisfy the certification test mentioned above, you are not a covered expatriate, and you are not subject to the exit tax.

  1. You are a U.S. citizen and a citizen of another country at birth. You remain as a citizen of and are taxed as a resident of that other country and have been a resident of the United States for no more than 10 of the last 15 tax years.
  2. You are under age 18½ on the date you expatriate and have been a U.S. resident for no more than 10 years.

How property is taxed

In general, all property (regardless of country) of a covered expatriate will be taxed as if it had been sold for fair market value on the day before the expatriation date. This is also often referred to mark to market or deemed sale. Certain gifts and assets you transferred up to three years before expatriation may also be subject to the deemed disposition tax.

The capital gains amount that would otherwise be included in gross income because of the deemed sale rule is reduced (but not to below zero) by $713,000 for 2018 (indexed for inflation). These three types of assets are exempt from the deemed sales rule, and are subject to their own special tax treatment:

1. Deferred compensation. Eligible deferred compensation items, including 401(k) plans, will only be taxed upon distribution and are generally subject to a 30 percent withholding tax. Ineligible deferred compensation items will be taxed as a deemed present value lump sum distribution.

"If you think you may be subject to the exit tax in the future, the best strategy is to avoid being treated as a covered expatriate or a long-term resident in the first place."

2. Tax-deferred accounts. This type of asset, including but not limited to traditional and Roth individual retirement accounts, will be taxed as a deemed lump sum distribution on the day before expatriation. The only special treatment here is you don't have to pay any early distribution penalties.

3. Interest in a non-grantor trust. This category will be treated similarly to eligible deferred compensation items mentioned above. In general, 30 percent in taxes will be withheld automatically when distributions are paid out.

You can make an irrevocable election to defer the deemed disposition tax on certain assets until it is actually sold, providing you meet all the requirements from the instructions for Form 8854. Or you can consider rolling your IRAs back to your employer's retirement plan at work, such as a 401(k), to avoid the deemed sale rule.

If you think you may be subject to the exit tax in the future, the best strategy is to avoid being treated as a covered expatriate or a long-term resident in the first place. The exit tax is only one of the many factors you need to consider before you decide whether or not to give up your U.S. citizenship or green card.

(Editor's Note: This column originally appeared on Investopedia.com.)

— By Jiyao Xu, co-founder and president, X and Y Advisors

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