Who exactly is a Covered Expatriate?

In 2008, President Bush signed the Heroes Earnings Assistance and Relief Tax (HEART) Act. One of the major provisions of the Heart Act was to collect substantial taxes from certain United States taxpayers (whether a citizen or a permanent resident alien) who expatriated from the United States after June 16, 2008. The individuals that this law applies to are known as "Covered Expatriates."

There can be harsh federal income tax and federal inheritance tax consequences if you are deemed to be a Covered Expatriate.

A person is considered a Covered Expatriate if he or she:
1) is a US citizen who renounced his or her citizenship OR a permanent resident alien who relinquishes his or her status after being a permanent resident alien for 8 of the last 15 years; AND
2) has had an average annual net income tax of more than $124,000 ($136,000 adjusted for inflation) in the preceding five years OR has a net worth equal to or more than $2,000,000 OR such person fails to certify, under penalty of perjury, that he or she has met the income and asset requirements.

Additionally, this statute does not apply to dual citizens who became a citizen of the United States by birth, but have never had substantial contacts with the United States. A person is considered to have substantial contact with the United States if he or she was ever a resident of the United States, ever held a passport OR was present in the United States for more than 30 days during any calendar year 10 years prior to the person giving up their United States citizenship. There is a slight variation on this rule for dual citizens who give up their US citizenship prior to age 18 and 1/2.

To learn more about who is a Covered Expatriate, wee Internal Revenue Code Section 2801 and Section 877A(g)(1).

Income Tax Consequences of Expatration

In this down economy, many companies are laying off employees. While this could be deeply troubling for those who get laid off, imagine if you were also subject to a huge income tax penalty as a result. This could be happening to you now if you are a permanent resident alien who decides to leave America after losing your job.

In 2008, President Bush signed the Heroes Earnings Assistance and Relief Tax (HEART) Act. This ironically named Act was designed to prevent wealthy people from leaving the United States before paying what Uncle Sam thinks they owed.

The Heart Act applies to citizens and permanent resident aliens who meet certain income and asset requirements. These individuals are known as "Covered Expatriates". To see who exactly Covered Expatriates are, read here.

The Heart Act created Section 877A of the Code. Section 877A takes a snapshot of your assets the day before you expatriate. Then, on the day you expatriate, you are then immediately taxed on the net built in gain which is in excess of $600,000 (indexed for inflation - so this amount is $627,000 in 2010). So, if you are a Covered Expatriate and own several real estate properties with built in gain of $1,000,000, there would be a deemed gain of $363,000, and you would have to pay a tax on that gain.

In the case of an IRA, but not most other retirement accounts, expatriates are also deemed to have received a distribution equal to their entire interest. Luckily, there is no early distribution penalty unless you actually do take the money out early. For most qualified and non-qualified retirement accounts, the IRS will continue their existing practice of requiring the employer to withhold 30% when the money is actually distributed from the account.

Perhaps the only positive feature of this law for those affected is that it does allow certain taxpayers to defer making payments on their tax obligations.

Note: There is an open question about whether Section 121 of the Code, which allows a capital gains tax exclusion on sale of primary residence, still applies to Covered Expatriates. It would probably be advisable to sell your primary residence before expatriating to avoid this issue and also to avoid having to obtain a valuation report for the property.