Those who live in the United States may choose to leave the country and live elsewhere, but if this will be a permanent change, they should be aware that they may face certain tax consequences. Expatriation occurs when a U.S. citizen chooses to relinquish their citizenship. Expatriation will also apply to a lawful permanent resident who holds a “Green Card” if their immigration status is revoked or abandoned or if they notify the IRS that they will be commencing residence in a country that has a tax treaty with the United States. Expatriates may be required to pay an exit tax, and they will want to understand how the tax laws will apply to their situation.

Who Is Subject to the Exit Tax?

The exit tax (also known as the expatriation tax) is a form of income tax that applies to the potential gains a person would earn by selling or disposing of the assets they own. While capital gains taxes typically apply to the profits a person earns when selling assets, a taxpayer may not actually realize these gains until years or decades after they leave the United States. Exit taxes ensure that the IRS can apply the proper taxes to the gains a person earned while they resided in the United States.

The exit tax will only apply if a taxpayer meets the qualifying criteria to be a “covered expatriate.” Three tests are used to determine whether a person is a covered expatriate:

Major financial transactions can have a variety of tax consequences, but taxpayers may be able to make use of tax laws and regulations to minimize the taxes they will be required to pay. Real estate transactions will often result in capital gains taxes being applied to the profits earned, but in some cases, a taxpayer may be able to use a “like-kind exchange” to defer the taxes owed. However, the Tax Cuts and Jobs Act (TCJA) of 2017 made some changes to the types of property that can be included in these exchanges, and the IRS recently issued new rules that will apply in these cases.

What Is a Like-Kind Exchange?

Section 1031 of the Internal Revenue Code allows taxpayers to defer capital gains taxes when selling certain types of property if the proceeds from the sale are reinvested into replacement property. The replacement property must be of a “like-kind” to the original property, meaning that it is property of the same type. Typically, business or investment property can be exchanged for other business or investment property.

Updated Rules for Section 1031 Exchanges

The TCJA restricted like-kind exchanges to real property used for business or investment purposes. It also eliminated certain types of personal or intangible property from being considered in these exchanges, including equipment and machinery, artwork and collectibles, vehicles, and patents or other intellectual property.

People who live in the United States are required to pay a variety of different types of taxes. Because the U.S. Tax Code is so complex, taxpayers are not always aware of issues that may affect the taxes they pay, and they may encounter situations that trigger unexpected tax obligations. In addition to paying taxes while residing in the United States, taxpayers will also need to meet certain requirements when moving to other countries.

U.S. citizens who plan to relinquish their citizenship or permanent residency “Green Card” holders who will no longer be lawful permanent residents of the United States will need to follow expatriation procedures with the IRS. In some cases, an exit tax may apply, or a person may face a tax audit based on his or her compliance with tax obligations in previous years. By working with a tax law attorney, these individuals can understand their obligations and take steps to minimize penalties and avoid ongoing tax issues.

Preparing for Expatriation

All expatriates are required to file Form 8854 for the year in which they terminated their citizenship or ended their residency in the United States. This form certifies that a taxpayer has complied with tax obligations in the 5 years prior to expatriation. Expatriates who defer tax payments or compensation or who have an interest in nongrantor trusts will need to file Form 8854 annually.

U.S. taxpayers who own offshore accounts or other foreign assets may struggle to understand their requirements for reporting foreign investments to the Internal Revenue Service (IRS) and paying taxes on foreign income. In some cases, these matters have become even more confusing following recent changes to the programs the IRS has made available to taxpayers. In 2018, the IRS ended the Offshore Voluntary Disclosure Program (OVDP), and recently, it also took down the Delinquent International Information Return Submission Procedures (DIISP) from its website. This has left many taxpayers concerned about their ability to become compliant with IRS requirements and avoid penalties related to reporting foreign assets and income.

What Is DIISP?

Previously, the DIISP allowed taxpayers to receive a waiver of the penalties that would normally apply to unreported foreign assets. Taxpayers could qualify for the DIISP if they did not have any unreported income, as long as they could show that they had reasonable cause for their non-compliance, such as death, serious illness, natural disasters, or ignorance of tax laws.

The IRS quietly ended the DIISP in November 2020 without providing any notice that these procedures would no longer be available. Without this option, taxpayers will be required to follow other procedures to become compliant, and they may be subject to tax penalties.

The U.S. Tax Code is very complex, and taxpayers will often struggle to understand their tax obligations, their requirements for filing tax returns and other forms, and the steps they should take to avoid penalties. Nonresident aliens (NRAs), or those who are not U.S. citizens or U.S. nationals and do not maintain a substantial presence in the United States, may have certain tax obligations, including the requirement to pay taxes on income generated by rental properties. Failure to file the proper forms and pay taxes on this income may result in tax audits and penalties.

Tax Requirements for Rental Income From Real Property

When an NRA acquires real property in the United States, that person will usually not be required to file any forms with the IRS or pay taxes. However, there will be tax on any income earned through the rental of this property. The tax rate that applies to this income will depend on whether it is considered passive income (known as FDAP income) or effectively connected income (ECI) that is associated with a U.S. trade or business.

FDAP income is generally taxed at a rate of 30% of the gross amount of income earned by a rental property. These taxes will usually be withheld by a withholding agent (such as a property manager, renter, or lessee) who will send this amount to the IRS. ECI, on the other hand, is subject to graduated tax rates, and taxes apply to net income earned after deductions and expenses.