Citizens and resident aliens living abroad might face one, or more, of these three tax code complexities when contemplating disposal of their U.S. property.

 

The 121 Exclusion

 

The current law provides for a generous exclusion of capital gains on sale of principle residence.  That was not always the case.  Until 1951, any capital gain on disposition of your abode was taxed along the same lines as any gain realized on a sale of the longer-held securities in one’s investment portfolio.  Then, came the Revenue Act of 1951, which granted to seller a significant reprieve, but did not truly allow for cashing in on a sale of an appreciated property.  The Act, in essence, permitted that the gain be deferred until the taxpayer acquired another principal residence of the same or greater value, thus encouraging “buying-up” and impeding the “buying-down” market behavior.  That feature of the old tax law was quite detrimental to any effective retirement planning.  What followed – the once-in-a-lifetime $125,000 capital gain exclusion - was a substantial relief for folks 55 and over, but was of no help to younger taxpayers, to include those that found employment abroad and were not in position to “buy-up” once they arrived to a foreign country.

 

Today, a couple filing a joint tax return can exclude up to $500,000 of capital gain on disposition of their primary residence.  Any gain in excess of the $500K, however, may not be rolled over to the next purchase, i.e. it is taxed in the year of sale.  That, perhaps, constitutes the only salient downside of the current section 121 regime.  Much has been made in income tax literature of the very definition of principal residence; the Internal Revenue Code (IRC) section 121, which governs the conditions and the mechanics of the exclusion, does not define it.  There are a few things to be aware of in interpreting what may and what may not be classified as you primary residence.  More about that later.

 

Section 121 calls for both, a two-year period of ownership and a two-year period of occupancy during the 5 years immediately preceding the sale.  The two, however, do not have to be concurrent.  For couples filing jointly (otherwise the amount of the exclusion is halved to $250,000) both parties would have to satisfy the use test; only one has to meet the ownership requirement. The occupancy can be an aggregate of 730 days; it does not have to be a continuous period of 24 months.  Furthermore, short absences, e.g. vacations or brief business trips, do not have to be subtracted from the periods of occupancy.

 

Scenario 1

 

Jack, a biotech executive buys a house on 6/2/2010 for $795,000 and moves in on 7/1/2010.  On 4/10/2013, Jack marries Jill, who the same day moves in with Jack.  The title to the house remains solely in Jack’s name.  A little more than a year later, Jack’s company offers him a promotion.  With the acceptance of the promotion, however, comes the move to Bangalore, India on 7/14/2014.  Jill, immersed in her promising career as a physician at a local clinic, stays behind.  In the spring of the following year, an opportunity presents itself for a suitable position for Jill at a Bangalore hospital.  Jill accepts the offer and joins Jack in India on 5/29/2015.  The house is rented out from 6/1/2015 to 11/30/2015.  On 12/11/2015, their agent back home sells the house for a net amount of $969,000.

 

Jack and Jill would be able to exclude the $174,000 gain on their joint 2015 tax return as Jack has met the ownership requirement and both, Jack and Jill have passed the use test.  Moreover, Jack could also exclude the entire gain on a married filing separate return – a likely outcome in light of the presumption that both have high levels of income.  Jill could not claim the exclusion on her married filing separate return, considering that she could not satisfy the ownership requirement.      

 

An additional requirement is the rather self-explanatory one of “one-sale-in-two-years”. 

 

What if one does not meet all of the section 121 conditions, but is compelled to sell the abode due to some pressing circumstances?  That would depend on the specifics of the taxpayer’s predicament.  Some mitigating circumstances are covered in section 121 U.S. Treasury regulations, a material change in suitability of the property and taxpayer’s impeded financial ability to maintain the property being among them. Among the safe harbors one finds a rather common theme: an unexpected uprooting of the family due to a geographic displacement of an employer.  This type of a situation (illustrated in “Scenario 2”) may provide for a partial exclusion of capital gain.

 

You also need to be careful not to be too clever in your interpretation of the concept of principal residence.  If you were to buy land in 2011 and park on that land a Winnebago, a subsequent construction of a house on that property in 2014 would unlikely result in meeting the section 121 ownership test by 2015.  In light of circumstances similar to the given example, the U.S. Tax Court ruled against the taxpayer in Maryanne Oxford v. Commissioner of the Internal Revenue.  For a residence to qualify as the principal residence, among other things, the dwelling must be considered a fixed structure under the local law – typically, a state law.          

 

Another aspect of the law that may lead to a costly miscalculation has to do with a potential misapplication of the continuity of ownership concept.  The Court’s decision in Gates v. Commissioner shows that relevant is the continuity of ownership of a dwelling and not that of land.  Accordingly, if you were to demolish your house and then, build another one in a different section of the same land parcel not out of an indisputable necessity, e.g. a severe termite damage, but due to any other reason, the ownership period for the purpose of section 121 would commence on the day you built the new house. 

 

Scenario 2

 

Roxanne is a manufacturing operations manager.  Roxanne and her husband, Theo, resided in a house at 2332 Maples Drive from 9/18/2013 to 4/1/2015.  Prior to June 20, 2014, the house was owned by Theo’s father, John.  On June 20, 2014, John gifted the house to Theo.  John purchased the house in 1979 for $105,000.  After accounting for the cost of all improvements and the gift tax that John would have to pay upon the transfer, John’s basis in the house on June 20, 2014, amounted to $200,000 (henceforth, these were Theo’s basis in the house).  In the spring of 2015, the company employing Roxanne moved its manufacturing facility to Philippines.  As during the recent years Theo could only find part-time employment, the couple decided to follow Roxanne’s employer.  In their absence, on October 9, 2015, their agent sold the house for a net amount of $430,000.  Accordingly, Theo realized a capital gain of $230,000.  

 

Theo and Roxanne have failed both, the ownership and the use section 121 test, but are likely to qualify for a partial exclusion of capital gain on the sale of their principal residence.  In order to determine the partial (fractional) exclusion amount, we would have to place in the numerator the shorter of the two periods, ownership or use.  It this case, it would be the former (476 days).  The denominator is 730, i.e. the number of days required for the full exclusion to apply.  Therefore, the couple should be able to exclude $149,173 of the gain (476/730 * $230,000), but would have to pay capital gains tax on the remainder.      

 

A health related reason behind an early disposition of your house may also allow for a partial capital gain exclusion, providing that the move to another location was recommended by a physician; a general presumption that the move would be beneficial to your health or the health of a member of your household is insufficient.  The person whose health is in question could be anyone who finds abode in your house and whose degree of relationship to you is cited in a rather broad list that that has been furnished by Regulation 1.121-3(d)(1).  A number of unforeseen circumstances – natural disasters and involuntary conversions being among them – round off the list of the justifiable reasons for claiming a partial exclusion.    

 

Part-Gift, Part-Sale

 

Let us suppose that upon making a firm decision to retire in the south of France or on the Pacific coast of Costa Rica, you and your spouse are leaning toward the idea of selling your principal residence to your daughter and the “newly acquired” son-in-law.  You have $475,000 basis in the property, which has a fair market value of $750,000.  Motivated by a desire to help the newlyweds, you sell the house to them for $600,000.  There are a few tax consequences to this transaction that need to be looked at:

 

A. You realize a capital gain of $125,000, which fits quite comfortably into the $500,000 capital gain exclusion.  

 

B. You also make a potentially taxable gift of $150,000 (the difference between the fair market value of the house and the sales proceeds). The question is, to what extent? If the names of both, your daughter and your son-in-law were to be on the deed, you can argue that $56,000 constituted a gift that is within the limits of the annual exclusion ($14,000 per donor and per donee, i.e. 2 * 2 * $14,000), leaving you another $94,000 to contend with.  This does not present a major obstacle, as you and your spouse each have a life-time exclusion on the [unified] amount subject to gift and/or estate tax of $5,430,000 (as of 2015).  That exclusion is portable, meaning if one of you were to pass, the other could potentially use an aggregate exclusion of up to $10,860,000.  Unless you have millions stashed in an investment portfolio and are concerned about future estate tax implications, the gift tax issue is a moot point.

 

C.  The basis to the buyers (and part donees) is the greater of the basis of the sellers (and part donors) or the selling price.  In this case, it would be the latter.  The only less desirable consequence is that in case the young couple is tempted to “flip” the house in less than two-years-time, they would end up with a $150,000 taxable capital gain, providing the FMV of the house remained at $750,000. 

 

Let us examine the same scenario with two significant modifications: (1) we will multiply all the numeric values above by 10 and (2) we will assume that you and your spouse, in addition to the principal residence, possess other assets with a total value of $8,500,000.

 

Capital Gains & Gift Tax Considerations                     Estate Tax Considerations

Sale Price                                                   6,000,000           Estate Value Before the Sale                  16,000,000

Your Basis                                                  4,750,000           Less FMV of the House                        (7,500,000)

Realized Capital Gain                                1,250,000           Plus Cash Proceeds                                 6,000,000

Sec. 121 Exclusion                                     (500,000)           Estate Value After the Sale                    14,500,000

Recognized Capital Gain                            750,000                                                                                 

Capital Gains Tax @ 20%                          150,000              Combined Life-Time Exclusion             10,860,000

                                                                                               Reduction due to sale                           (1,444,000)

Fair Market Value                                    7,500,000             Remaining Life-Time Exclusion              9,416,000

Sale Proceeds                                            6,000,000                                                                              

Amount of Gift                                         1,500,000            Potentially Subject to Estate Tax             5,084,000

Annual Gift Exclusion                               (56,000)            Potential Estate Tax @ 40%                     2,033,600

Taxable Gift                                              1,444,000                                                                              

Applied to Life-Time Exclusion             (1,444,000)

 

 

We will not introduce the Net Present Value factor to this analysis in order not to overcomplicate things for the purpose of a merely introductory white paper.  Nonetheless, it should be apparent that if we were to repeat the same tactic as before for someone with a substantially greater net worth, the outcomes differ significantly.  In addition to a $150,000 in capital gains tax, there is looming on the horizon an estate tax of $2,033,600.  Is there an obvious remedy?  If the house was sold at its FMV, the resulting recognized long-term capital gain would be $2,250,000 and the corresponding capital gains tax $450,000.  The estate value would remain at $16,000,000 and the still intact aggregate life-time exclusion would be $10,860,000.  The other option for gifting would be to make continual, annual, monetary gifts, as opposed to conveying the house in a bargain sale.  It would take a little over 14 years of distributing $56,000 in annual, exclusion-covered gifts before the potential aggregate tax liability equaled the one from the table above.  However, if there were kids entering into the calculation and, as a consequence, an increased amount of excludable per annum gifts, that equilibrium could be reached much earlier.  Naturally, as with anything that plays out over time, there are economic and actuarial variables that need to be considered, such as the inflation rate, performance of investment portfolios, and one’s longevity.

 

This is a hazard-prone and fairly complex area of tax planning.  I have compiled the paragraphs above more so for awareness purposes.  Depending on your net worth and family circumstances, gift and estate tax planning should be inseparable from your other tax planning considerations.

 

Expatriation Tax

 

An unpleasant surprise lays in store for those of you who wish to renounce your U.S. citizenship or permanent residence and fall into any of the three categories:

 

1. Your five-year average of annual income tax (adjusted for the foreign tax credit) exceeded certain threshold ($160,000 in 2015)

2. Your net worth is equal to or is greater than $2,000,000 on the day of expatriation or termination of residency;

3. You fail to certify on IRS Form 8854 that you have complied with all U.S. federal tax obligations for the 5 years preceding the date of your expatriation or termination of residency.

         

Certain persons born as dual citizens of the U.S. and one other country, as well some individuals who have ended up being categorized as U.S. permanent citizens pursuant to an application of the substantial presence test, are exempt.  IRC 877A, the tax code section that governs the application of the expatriation tax, imposes a mark-to-market regime, meaning all property of a “covered expatriate” is deemed sold at its FMV on the day before the expatriation (for example, the day one renounces their citizenship before a diplomatic or consular officer of the U.S.).  The yardstick used here is essentially the so-called built-in-gain (or loss).  The deemed sale is reported to the IRS on Form 8854 (Initial and Annual Expatriation Statement).  What assets enter into the calculation?  The IRS Notice 2009-85 indicates that for purposes of determining the tax base, a covered expatriate is deemed to "own any interest in property that would be taxable as part of his or her gross estate for Federal estate tax purposes under Chapter 11 of Subtitle B of the Code as if he or she had died on the day before the expatriation date as a citizen or resident of the United States."

 

Some assets – among them, 401(K) account balances and deferred compensation – are excluded from that base.  The kicker in 877A is this: the deemed sale covers your worldwide assets.  If you believe that your estimated range of the fair market value of your total assets closely straddles the $2,000,000 figure, you would be well served by engaging a qualified appraiser (as defined under IRS section 170(f)(11)).  If among your assets is stock of a closely held corporation, you may want to consider to valuate the business entity in accordance with the requirements of the Revenue Ruling 59-60.  

 

For the calendar year 2015, there is an exclusion in an amount of $690,000.  The exclusion is applied proportionally to each deemed sale, but not to those transactions that result in a capital loss.  For example:

 

You have assets with an aggregate FMV of $3,000,000, among them a house that has a fair market value of $850,000 and basis of $500,000.  The deemed realized capital gain would be $350,000.  The applicable exclusion amount would be $195,500 (850,000/3,000,000 * $690,000).  Accordingly, you would face paying tax on $154,500 (in addition to other taxable amounts).  Perhaps you would say: “Wait a minute, what happened to that section 121 exclusion?”  There is none, the treatment under section 877A offers no palliatives; 121 exclusion and other features of the code design to mitigate your tax exposure simply become unavailable.  The aggregate un-excluded amount is taxed on one’s exit return.  However, the gain from the deemed sale is added to the subsequent basis of the house.  

 

That, however, is not the end of it.  When you actually sell the house you may be liable for a capital gains tax in your new country of residence.

 

If you fall into category “2” above, your pre-expatriation tax planning should include, among other things, (a) giving a serious consideration to making gifts of appreciated assets and (b) considering selling your principal residence (if you are otherwise qualified to call your U.S. property principal residence) before you expatriate or surrender your permanent resident status. 

 

The examples provided above are generic and largely introductory in nature; by no means this exhausts all possible outcomes.  If you believe you could be affected by one or more of these three tax code domains, you should explore it in the context of your particular circumstances.  

 

IMPORTANT DISCLOSURES

 

The presented here information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

 

The information contained herein is of a general nature and based on authorities that are subject to change.  Moreover, the information is presented here for educational purposes and is not specific to any individual’s personal circumstances.  As such, this information should not be used for the purpose of avoiding penalties that may be imposed by law.  A determination as to how your specific circumstances may relate to the presented material should be made by means of a consultation with your tax adviser.

 

Cezary Tchorznicki, CPA LLC does not provide legal or investment advice.