What Is the Exit Tax? Everything You Need to Know Before Expatriating

Leaving the United States to live abroad for a more comfortable lifestyle might be a perk but to some, a long term green card or United States citizenship can be seen as a burden given the rest of the premium nation immigration policies. However, when it comes to the ‘U.S. exit tax’ will put your hard earned income at stake. This tax as per IRC 877A puts a cap of sorts and does not allow tax expatriates to abandon the American tax system entirely. 

If you’re thinking about expatriating, it’s important to understand who falls under this and the U.S. exit tax ‘planning’ can be structured to mitigate the negative impact as best as possible. 

Introduction: What Is the Exit Tax?

It is a tax that expatriates are subjected to when leaving the United States or becoming a long term resident to the country. The U.S. exit tax is a type of capital gains tax the IRS assumes, as on the last days before expatriating, you sold every asset you own, and dominantly applies to appreciated unrealized gains that are above a certain exclusion limit. The reasoning is, to not allow rich people to move out of America seamlessly.

Who Is Subject to the Exit Tax?

No individual renouncing U.S. citizenship is guaranteed to pay the exit tax. The IRS has three primary criteria for determining if you are a covered expat:

• Net Worth Test: If a person’s net worth is $2 million or more on the expatriation planning date, that person is a covered expatriate by default.
• Average Income Tax Liability Test: If a person’s average annual U.S. tax return in the previous five years is above a certain amount, that person is covered (2024: $202,000)
• Certification Test (Form 8854): U.S. exposed net worth or tax liability does not matter for covered expats who fail to submit Form 8854 and assert compliance with U.S. tax obligations for the 5 years.
• Green Card Holders: These are long term and those who have possessed a green card for 8 out of the last 15 years. They are also liable to the rules if they abandon their residency.

How Is The Exit Tax Calculated?

The IRS follows a mark-to-market approach:

• All global assets are deemed to be sold on the day prior to expatriation.
• Unrealized gains are subjected to U.S. capital gains tax.
• You may exclude the first $821,000 of gain (figure for 2024, modest yearly inflation adjustments). All gains above this amount are taxed and treated as capital gains.

Special Rules for Certain Assets

• Retirement Accounts & IRAs: Like most of the world, they are considered as fully distributed in the form of cash as of the day before the expatriation, with tax payable as of that date.
• Deferred Compensation Plans: May be subject to withholding.
• Trust Interests: More easily said than done, and they involve complex rules in most instances and are usually best dealt with when it is too late.

How to Prepare Before Renouncing

Understanding this is not a decision that may, at first, seem easy to make, and in undertaking the requisite planning, you may be able to preserve up to 7 million dollars.

1. Form 8854 Compliance: This form must be completed and submitted in order to not be a covered expatriate.
2. Ex-Poste Tax Planning
   1. Gifting Assets: This is a strategy that may be used to decrease one’s net worth below the 2 million mark.
   2. Charitable Donations: These may be used to defray taxable gains.
   3. Timing Sales: You may be able to sell assets and, in so doing, treat the proceeds as taxable gains, in relation to expatriation tax. 
3. Professional Guidance: Retain a tax lawyer with expertise in cross-border law who will elegantly untangle matters in order to reduce the tax payable.

Common Mistakes and Penalties

• Failure to Submit Form 8854: This is treated as a form of non-compliance, and you, in this case, will automatically be treated as a covered expatriate.
• Failing to File an FBAR or FATCA: These reports not only give indications of what must be done, but the penalties you will face, even before expatiating, may be suffered as a result of the unfiled reports.
• Mistakes in the valuation of real property, business holdings, or even trusts can exceed net worth tests and net $2 Million over the line, which isn’t where you want to be.

Alternatives and Workarounds

There are some strategies to lessen or completely remove a U.S. exit tax liability altogether:

• Lower Net Worth Prior To Exit: Making gifts to family members or family trusts.
• Restructure Investments: Shifting investments to those which will have the lowest recognized gains.
• Citizenship Planning: In some exceptional situations there is the possibility of addressing dual citizenship earlier to lessen the duration of the tax.

How DimovTax Can Help

At Dimov Tax, we help clients navigate the complex U.S. exit tax landscape with precision and foresight. Contact us today for our dedicated services. Our services include:

• Design and Analysis of Exit Tax Planning: Tailored Calculation of your IRC 877A exposure
• Form 8854: Ensure compliance in filing and reporting to avoid hefty penalties.
• Transactions between Two Countries Taxation: Coordinating with other countries to avoid the country imposing the second tax.
• FBAR and Fatca: Your form and reports of these, to be brought before the US in compliance before you exit.

As long as the planning is done in advance, your transition to a new country can be done without major pitfalls.

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