Capital Gains Tax for Expatriates
Capital Gains Tax for Expatriates: When a US person becomes an expatriate, from a US tax system perspective they are generally thought of as a nonresident alien. And, if a person is a covered expatriate, then the taint of the US tax system may follow them throughout their life. This is no more apparent than in a scenario in which a covered expatriate wants to give a gift or bequest to a US person in accordance with Internal Revenue Code (IRC 2801 with regulations still pending). But what happens after the expatriate leaves the United States and still maintains investments in the United States or invests into the US economy after they are an expatriate — can the IRS tax the expatriate?
Let’s take a look at how the general capital gains tax rules apply to expatriates:
What is FDAP?
Nonresident aliens with US sourced income that is not considered effectively connected income (ECI) — such as effectively connected to a US trade or business is generally referred to as FDAP or Fixed, Determinable, Annual or Periodical. For the most part, FDAP is typically investment income — although there are types of FDAP which may not be immediately thought of as passive income on first glance — such as a covenants not to compete.
When it comes to FDAP, the tax rules involving which types of income are taxable to nonresident aliens are a bit different than how passive income is taxed to US persons.
Capital Gains Exemption (Limited)
One benefit is that generally (subject to exceptions, exclusions and limitations) US generated capital gains are not taxable to a nonresident alien — assuming that they do not meet the 183-day test.
Since the capital gains are not taxed in accordance with the US tax law, the expatriate may be able to plan their tax residence so as to not generate tax on US capital gains in their tax home.
It is important that the expatriate plan before performing the expatriating act because once they expatriate, they cannot unwind the expatriating act.
As provided by the IRS:
- “If you were present in the United States for 183 days or more during the tax year, and you are still a nonresident alien, your net gain from sales or exchanges of capital assets is taxed at a 30% (or lower treaty) rate. For purposes of the 30% (or lower treaty) rate, net gain is the excess of your capital gains from U.S. sources over your capital losses from U.S. sources. This rule applies even if any of the transactions occurred while you were not in the United States. The183-day test mentioned above is not the same as the 183-day test used in the substantial presence test.
- See The Taxation of Capital Gains Of Nonresident Alien Students, Scholars and Employees of Foreign Governments for further information.
- If you were in the United States for less than 183 days during the tax year, you will not be taxed on your capital gains, except for the following types of gains:
- Gains that are effectively connected with a trade or business in the United States during your tax year
- Gains on the disposal of timber, coal, or domestic iron ore with a retained economic interest
- Gains on certain contingent payments received from the sale or exchange of patents, copyrights, and similar property
- Gains on certain transfers of all substantial rights to, or an undivided interest in, patents
- Gains on the sale or exchange of original issue discount obligations
- Many tax treaties contain provisions which reduce or eliminate taxation on capital gains.”
What does this mean?
It means that once a US person becomes an expatriate, they no longer have to pay US tax on capital gains and it will not be withheld at the typical 30% withholding tax rate for other types of FDAP. But. if the nonresident is in the United States for 183 days during the current tax year then they will be taxed at 30% although it may be reduced by treaty rules (if there is a treaty in place between the two countries).
In addition, some capital gains from the United States are still taxable.
This is especially true in situations in which a foreign person owns US real estate or USRPI – and the FIRPTA rules kick-in.
Planning for Post-Expatriation U.S. Tax
In conclusion, once a person expatriates from the United States and is considered a nonresident alien they will escape US tax on many different types of US investments. But, the US does reserve the right to tax capital gains in certain situations such as if the nonresident alien overstays their welcome in the United States in the current year — or is generates capital gains of certain non-excludable assets.
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