Exit Tax Explained: A US Expats' Guide to Expatriation Tax (2024)

I often encounter US expats who express concern about the potential exit tax they may face upon renouncing their US citizenship. However, the reality is that most expats will never pay this tax. In this comprehensive article, I’ll explain the intricacies of the exit tax and why US expats shouldn’t be alarmed by it.

Do I have to pay exit tax if I renounce my citizenship?

Not every individual who renounces their US citizenship will have to pay exit tax. The exit tax applies primarily to “covered expatriates,” a category that includes people who meet certain thresholds regarding their net worth, taxable income, and tax compliance. If you do not fall under the covered expatriate definition, you will not be subject to the exit tax.

Moreover, even if you are a covered expatriate, you may not owe exit tax thanks to the $767,000 exemption on capital gains. As a US expat, it’s important to consider your types of property and types of assets in relation to the exit tax. For instance, deemed dispositions of personal property and primary residence may be subject to capital gains tax, while certain financial accounts and interests in non-grantor trusts have special tax treatment.

What is deemed disposition?

A deemed disposition is a tax concept that treats certain assets as if they have been sold, even though no actual sale has occurred. This notion is used in various tax jurisdictions to establish a taxable event, triggering the calculation of capital gains or losses for tax purposes.

Understanding the Exit Tax

The exit tax, also known as the expatriation tax, is a provision under the Internal Revenue Code (IRC) Section 877A, which aims to tax certain individuals who decide to give up their US citizenship or green card status. The exit tax is often misunderstood and feared by expats, but it’s essential to note that it’s applicable only to “covered expatriates” – not every person who renounces their citizenship.

According to IRC Section 877(a)(2), a covered expatriate is someone who meets any of the following criteria:

Has an average annual net income tax liability for the five years preceding the expatriation year exceeding a specified threshold (adjusted for inflation, $178,000 for 2022);
Has a net worth of $2 million or more on the expatriation date;
Fails to certify, under penalties of perjury, compliance with all US federal tax obligations for the five years preceding the expatriation year.

It’s important to remember that the exit tax is not a punishment for renouncing citizenship; rather, it’s a mechanism to ensure that individuals who have significantly benefited from their US citizenship pay their fair share of taxes on their assets before leaving the US tax system.

If I’m a covered expatriate, will I be subject to exit tax?

As a covered expatriate, you may be subject to the exit tax, but it’s crucial to note that many covered expatriates will not actually owe any exit tax. This is because the exit tax calculation involves determining the taxable capital gain on the deemed sale of your worldwide assets, and the first $767,000 of gains (adjusted for inflation) is exempt.

When calculating your exit tax liability, consider the types of property and types of assets you own, such as personal property, financial accounts, and real estate in your host country or foreign country. The deemed dispositions of these assets may result in capital gains or losses that impact your exit tax liability.

Calculating the Exit Tax and the $767,000 Exemption

The exit tax is calculated based on the “deemed sale” of an individual’s worldwide assets on the day before their expatriation. This means that the expatriate is assumed to have sold all their assets at their fair market value and would be subject to tax on any gains.

However, there’s a significant exemption available to covered expatriates, which alleviates the tax burden for many. As of 2023, the first $767,000 of gains (adjusted for inflation) is exempt from the exit tax, per IRC Section 877A(a)(3)(A). This means that only gains exceeding the $767,000 threshold are subject to the exit tax. Consequently, a majority of US expats who renounce their citizenship will not be subject to the exit tax due to this generous exemption.

Additionally, certain assets are excluded from the deemed sale calculation. For example, deferred compensation items, specified tax-deferred accounts, and interests in non-grantor trusts are not subject to the deemed sale rule. Instead, they are subject to special tax treatment, as outlined in IRC Section 877A(c) and (d).

In practical terms, the exit tax calculation involves several steps:

Determine the total fair market value of all worldwide assets, excluding those exempt from the deemed sale rule;
Calculate the total gain or loss resulting from the hypothetical sale of these assets;
Apply the $767,000 exemption (or the adjusted amount for inflation);
Calculate the tax liability on the net gain, if any, exceeding the exemption threshold.

The Importance of Proper Tax Planning

Proper tax planning is crucial for US expats considering renouncing their citizenship. A tax professional can help identify potential issues, including the likelihood of being classified as a covered expatriate and the estimated exit tax liability.

By engaging in proactive tax planning, US expats can potentially mitigate their exit tax liability through strategies such as:

Accelerating income recognition before expatriation to reduce gains subject to the exit tax;
Deferring the realization of gains until after expatriation, provided that the expat does not meet the covered expatriate criteria;
Gifting assets to reduce net worth below the $2 million threshold;
Ensuring compliance with all US federal tax obligations for the five years preceding the expatriation year.

It’s important to note that each individual’s situation is unique, and the strategies mentioned above may not be appropriate for everyone.

Common Misconceptions About the Exit Tax

There are several misconceptions about the exit tax that often lead to unnecessary fear and confusion among US expats:

All US expats are subject to the exit tax: As previously discussed, only covered expatriates are subject to the exit tax. Most US expats will not meet the criteria for being classified as a covered expatriate and will not be subject to the tax.
The exit tax applies to all assets: Some assets, such as deferred compensation items, specified tax-deferred accounts, and interests in non-grantor trusts, are not subject to the deemed sale rule and are subject to special tax treatment.
Renouncing citizenship is the only way to avoid the exit tax: This is not true. With proper planning, it is often possible to mitigate or even eliminate exit tax liability by taking steps to reduce net worth, manage unrealized gains, and ensure compliance with US tax obligations.

While the exit tax may seem daunting for US expats considering renouncing their citizenship, it’s important to understand that most expats will not be affected by this tax. With the generous $767,000 exemption and the specific criteria for being a “covered expatriate,” it’s crucial not to let fear of the exit tax overshadow the decision-making process.

What If I’m Behind on My US Tax Returns?

If you are behind on your US tax returns and considering renouncing your US citizenship, it’s important to become compliant with your tax obligations first. In order to renounce your US citizenship, you must be compliant for five years and file six years of FBARs (Report of Foreign Bank and Financial Accounts).