Mark-to-Market (Category 3) Notice 2009-85
Mark-to-Market & IRS Notice 2009-85: When U.S. Persons are considering expatriation, one of the biggest concerns (of course) is the IRS mark-to-market computation. Presuming an expatriate meets the definition of a covered expatriate, they will then have to perform a mark-to-market analysis to determine their unrealized capital gain on the day before expatriation. Not all property is subject to the MTM analysis (for better or for worse). And, some property is excepted under the rules, while other property may receive a step-up-basis.
Let’s take a look at how the Mark-to-Market is summarized in Category 3 of Notice 2009-85:
Which Property is Included?
As provided by the IRS Notice:
“Identification of Property & Fair Market Value
“For purposes of the mark-to-market regime, the covered expatriate is deemed to have sold any interest in property that he or she is considered to own under the rules of this paragraph other than property described in section 877A(c).
For purposes of computing the tax liability under the mark-to-market regime, a covered expatriate is considered 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. Whether property would constitute part of the gross estate will be determined without regard to sections 2010 through 2016.
In addition, for this purpose, a covered expatriate also is deemed to own his or her beneficial interest(s) in each trust (or portion of a trust), that would not constitute part of his or her gross estate as described in the preceding sentences. The covered expatriate’s beneficial interest(s) in such a trust shall be determined under the special rules set forth in section III of Notice 97-19, 1997-1 C.B. 394.”
“In computing the tax liability under the mark-to-market regime, a covered expatriate must use the fair market value of each interest in property as of the day before the expatriation date in accordance with the valuation principles applicable for purposes of the Federal estate tax, except as otherwise provided in this paragraph.
Specifically, fair market value will be determined under section 2031 and the regulations thereunder, but without regard to sections 2032 and 2032A, as if the covered expatriate had died as a citizen or resident of the United States on the day before the expatriation date. For these purposes: (a) the provisions of sections 2701 through 2704 will be applied as if the covered expatriate’s interests subject to those provisions were being transferred to family members; (b) the covered expatriate’s tax liability as a result of section 877A, or otherwise, will not be taken into account; and (c) sections 2055, 2056, 2056A, and 2057 will not be taken into account.
A covered expatriate must determine the fair market value of his or her beneficial interest in each trust, other than a nongrantor trust subject to section 877A(f), to the extent the trust would not constitute part of his or her gross estate, in accordance with the Federal gift tax valuation principles of section 2512 and the regulations thereunder without regard to any prohibitions or restrictions on such interest.
An interest in a life insurance policy will be valued in accordance with Treas. Reg. § 25.2512-6 as if the covered expatriate had made a gift of the policy on the day before the expatriation date.”
Deemed Sold Day Before Expatriation
The key component to a covered expatriate’s potential exit tax consequence is the mark-to-market analysis.
Essentially, the market-to-market analysis requires the covered expatriate to determine the Fair Market Value FMV value of the assets on the day before expatriation.
Then, the adjusted basis of the property (for each property) is subtracted from the FMV to arrive at the gain (or loss) and potential tax liability.
Allocation of the Exclusion Amount
“The exclusion amount, as described in section 877A(a)(3), must be allocated among all built-in gain property that is subject to the mark-to-market regime and is owned by the covered expatriate on the day before the expatriation date, regardless of whether the covered expatriate makes an election to defer tax with respect to any such property pursuant to section 877A(b).
Specifically, the exclusion amount must first be allocated pro-rata to each item of built-in gain property (“gain asset”) by multiplying the exclusion amount by the ratio of the built-in gain with respect to each gain asset over the total built-in gain of all gain assets.
The exclusion amount allocated to each gain asset may not exceed the amount of that asset’s built-in gain. If the total section 877A(a) gain of all the gain assets is less than the exclusion amount, then the exclusion amount that can be allocated to the gain assets will be limited to the total section 877A(a) gain.
Each individual is eligible for only one lifetime exclusion amount. Thus, if a covered expatriate becomes a U.S. citizen or long-term resident, and then loses such citizenship or ceases to be a lawful permanent resident and thereby becomes a covered expatriate subject again to section 877A, the exclusion amount with respect to the individual on a second expatriation is limited to the unused portion of his or her exclusion amount remaining (if any) after the first expatriation, as adjusted for inflation.
For example, if a covered expatriate used one third of the exclusion amount for the first expatriation, he or she will have two thirds of the exclusion amount available, as adjusted for inflation, in the event of a second expatriation.”
Basics of How the Exclusion Works
Once the properties are parsed out and categorized, they are next ready for the mark-to-market calculation.
The exclusion is applied proportionally to each asset – noting it cannot generate a loss. If the total value, including the exclusion nets zero, the there is no mark-to-market gain (but no loss).
You only get one exclusion in a lifetime, no matter how many times you expatriate in the future — but if you do not use the full exclusion, you can use the remainder in a subsequent expatriation.
Wash Sale Rules
“After allocating the appropriate amount of the exclusion amount among the gain assets, the covered expatriate must report gains and losses on the appropriate Schedules and Forms depending upon the character of each asset.
Losses may be taken into account only to the extent permitted by the Code, except that the wash sale rules of section 1091 do not apply. Thus, for example, losses are subject to the limitations of section 1211(b).”
What is a Wash Sale?
A Wash Sale is when a stock is sold to take advantage of a loss, and then to repurchase the stock within a short-period of time. Generally, those types of losses are limited (Subject to professional trader exceptions), but they are not prevented in the world of expatriation.
Adjustment to Basis of Property
Section 877A(a) requires proper adjustments to be made in the amount of any gain or loss subsequently realized with respect to an asset for the amount of gain or loss taken into account under section 877A(a)(2) with respect to that asset.
In making such adjustment, the basis of the asset will be adjusted by the amount of gain or loss taken into account under section 877A(a)(2)(A) and (B), without regard to the exclusion amount provided in section 877A(a)(3).
Examples are provided in the notice, and we will summarize them in a separate post for you.
In-bound step-up in basis for NRA becoming resident aliens
“Section 877A(h)(2) provides that, solely for purposes of determining the tax imposed by reason of section 877A(a), property that was held by a nonresident alien on the day that individual first became a resident of the United States (within the meaning of section 7701(b)) will be treated as having a basis on such date of not less than the fair market value of such property on such date.
A covered expatriate to whom this basis adjustment rule applies may make an irrevocable election, on a property-by-property basis, not to have such rule apply. The election must be made on Form 8854, which must be filed with the covered expatriate’s Federal income tax return for the taxable year that includes the day before the expatriation date. See section 8 of this notice for information concerning Form 8854.
The IRS and Treasury Department intend to exercise their regulatory authority to exclude from this step-up-in-basis rule United States real property interests within the meaning of section 897(c) (“USRPIs”) and property used or held for use in connection with the conduct of a trade or business within the United States.
Thus, if on the date the nonresident alien first became a resident of the United States, the nonresident alien held property that was a USRPI or was property used or held for use in connection with the conduct of a trade or business within the United States, then the basis of such property may not be stepped up to fair market value under 877A(h)(2).
If, however, prior to becoming a resident of the United States, the nonresident alien was a resident of a country with which the United States had an income tax treaty, and the nonresident alien held property used or held for use in connection with the conduct of a U.S. trade or business that was not carried on through a permanent establishment in the United States under the income tax treaty of such country and the United States, then that property is eligible for a step up in basis to fair market value under 877A(h)(2).”
The IRS provides that under certain circumstances a person may be entitled to a step-up basis on certain property they owned before they became a U.S. Person.
Instead, the basis will be no less than the FMV on the day they became a U.S. Person.
Deferral of Payment of Mark-to-Market regime
“Deferral election. Section 877A(b) provides that a covered expatriate may make an irrevocable election (“deferral election”) with respect to any property deemed sold by reason of section 877A(a) to defer the payment of the additional tax attributable to any such property (“deferral assets”).
The deferral election is made on an asset-by-asset basis.
In order to make the election with respect to any asset, the covered expatriate must provide adequate security (defined below) and must irrevocably waive any right under any U.S. treaty that would preclude assessment or collection of any tax imposed by reason of section 877A.
If the IRS subsequently determines that the security provided for the deferred tax no longer qualifies as adequate security, the deferred tax and interest will become due immediately, unless the covered expatriate corrects such failure within 30 days after the IRS mails notification of such failure to the last known addresses of the covered expatriate and the covered expatriate’s U.S. agent.
Subject to the preceding sentence, the time for payment of the tax attributable to a particular deferral asset under the mark-to-market regime is extended until the earlier of the due date (without extensions) of the covered expatriate’s income tax return for (a) the taxable year in which the asset is disposed of by sale, non-recognition transaction, gift, or other means, or (b) the taxable year that includes the date of death of the covered expatriate.
However, a covered expatriate may pay any tax deferred under section 877A(b), together with accrued interest, at any time.
Interest accrual. Section 877A(b)(7) provides that for purposes of section 6601, the last date for the payment of tax will be determined without regard to the deferral election. Interest will be computed at the underpayment rate established under section 6621 from the due date of the return (without extensions) for the taxable year that includes the day before the expatriation date and will compound daily under section 6622 until the date the tax is paid.
Waiver of treaty benefits. Section 877A(b)(5) provides that a covered expatriate may not make a deferral election with respect to a particular asset unless the covered expatriate makes an irrevocable waiver of any right under any U.S. treaty that would preclude the assessment or collection of any tax imposed by reason of section 877A.
The covered expatriate must make the waiver on Form 8854, which must be filed with the covered expatriate’s Federal income tax return for the taxable year that includes the day before the expatriation date. See section 8.C of this notice.
Additionally, acknowledgment of such waiver must be noted in the agreement to defer tax with respect to a particular property (“tax deferral agreement”) as described below.”
Deferring the Mark-to-Market Tax
A covered expatriate may seek to avoid the mark-to-market gain on specific property, by posting a bond or other alternative security.
This can be a costly endeavor for the covered expatriate.
First, they will continue to have to file the Form 8854 each year, even if they had no other reason they would have to do so.
In addition, the security can be costly and interest will continue to accrue.
Moreover, the Covered Expatriate must also make an irrevocable treaty waiver.
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