For those who do not want to read this post. Here is the bottom line:
If you are a tax compliant U.S. citizen abroad, with a net worth of less than two million U.S. dollars, with investments (including mutual funds, pensions, and a principal residence in your country of residence), you should renounce your U.S. citizenship at the earliest possible moment. To the extent that your investments are in non-U.S. mutual funds, other kinds of PFICs or your principal residence, the U.S will confiscate large amounts of the proceeds of sale. (And you thought you were solving your problems be being tax compliant.)
Many Canadians are using their principal residence as their retirement plan. Their plan is to sell, downsize and live of the balance of the proceeds. This is NOT possible if you are a tax compliant U.S. citizen! You must NOT be a U.S. citizen at the time the investments are sold.
If you want to preserve your investments you must relinquish your U.S. citizenship to protect your access to your investments!
For those who want to understand why, read on …
Tax compliance and the U.S. citizen abroad
It has become clear for U.S. citizens abroad that the only thing worse than NOT being tax compliant is BEING tax compliant.
The cost of U.S. tax compliance is that your U.S. citizenship will disable you from effective financial and retirement planning. The reason is that the U.S. considers most non-U.S. investment vehicles to be PFICs. The sale of your principal residence will be subject to a capital gains tax. Furthermore, the additional “Obamacare taxes” imposed on investment income will make the situation worse.) The above tweet references a very good article explaining why, for U.S. citizens abroad, retirement planning is hazardous to your financial health.
The main point is this:
If you you own a principal residence or a non-U.S. mutual fund and you sell it (you will want to do this at some point) all the gains (and possibly more will be confiscated). Since some of you may think I am sounding “alarmist” I will quote from the above article by tax lawyer Virginia La Torre Jecker (yes, somebody else thinks so too):
Don’t Mind Losing Your Investment ? PFIC Means Very Harsh Tax Consequences
The harsh bite of the PFIC tax rules will make itself known in either of two events: 1) when the fund makes a distribution (called an “excess distribution”) to the investor or, 2) when the investor disposes of his PFIC shares (a “disposition” of PFIC shares can occur by redeeming them, selling them, gifting them away, or even by giving up one’s US resident status or citizenship). When taxation occurs, the amounts will be taxed at the highest ordinary income tax rate for the investor without regard to other income or expenses (currently the highest individual rate is 39.6% plus, don’t forget the 3.8% Medicaid Surcharge). Long-term capital gains treatment does NOT apply.
To add insult to injury, the amounts on which the PFIC tax is to be calculated are “thrown back” evenly over each of the tax years that the investor held his shares. Tax is then assessed for each prior year at the highest possible tax rate that was in effect at such time. Then, interest is compounded on the deferred tax deemed due for each year. These high rates can very easily eat up the investment by removing the benefit of any tax deferral. If an investor has held his PFIC shares for many years, he can basically say goodbye to that investment. By way of example, assume Taxpayer redeems his PFIC shares at a gain of $10,000 in 2013. Assume he held the shares commencing 2009. In this case, $2,000 of gain will be deemed to have been earned in each of the five years 2009 through 2013. Tax will be assessed at the highest possible tax rate for each year and compounded interest will apply on the taxes due. Various tax elections can possibly be made to avoid this harsh treatment. Making an election, however, is not always a simple matter since certain requirements must be satisfied. Many times, the requirements cannot be met and the taxpayer is left in the lurch.
What does this mean practically?
It means that you may have to renounce your U.S. citizenship in order to save your financial future. This is why the issue of being a “covered expat” is becoming more and more important. If you are NOT a covered expat, you will get your “Get of Jail Free Card” for free. You are NOT subject to the mark to mark exit tax rules. If you are a “covered expat” there will be a deemed sale of your mutual funds (and all the horror that this sale implies). You cannot afford to be U.S. citizen when you sell your investments.
U.S. citizens abroad who:
1. are tax compliant
2. have investments they do not want confiscated by the U.S. government
3. have a net worth of less than two million
4. are not paying more than about 150,000 per year in taxes should:
Renounce your U.S. citizenship now!
It’s necessary to preserve your financial future. If you continue your habit of “tax compliance” (playing by the rules) and you reach the two million mark which is inevitable, you will be locked in a fiscal prison the rest of your life!
Caveat: Those who were born dual citizens and meet other requirements may “Get out of jail free” in any event.
Epilogue – Added one day later …
An interesting discussion which touched on the issue of non-U.S. mutual funds has been taking place at the Isaac Brock Society. See this thread.
Note this comment in particular. Note specifically the words I have bolded. Do NOT see these investments until you are no longer a U.S. person!
Ignore this if you plan to reside in the US permanently. Also, I have no idea whether this option would still be available to you if you have already filed returns using the MTM method for PFICs.
Have you examined reporting your PFICs under the excess distribution method? Under this method, you pay tax only on the dividends distributed by the underlying PFICs. Most of the dividends will be treated as ordinary dividends in the year the dividend was received. Dividend distributions in excess of 125% of the three year average are deemed excess distributions and the excess portion as apportioned over the holding period and taxed at the highest marginal rate in the period plus interest. However, it avoids having to pay “capital gains” tax on a MTM basis which is where you can get whacked by dollar depreciation or underlying fund appreciation or both. If the underlying funds you held paid a fairly stable rate of dividends from year to year then most of the dividends will be treated as ordinary dividends.
Additionally, I’ve had two different sets of tax preparers tell me that only dividends from Income class shares need to be reported as dividends since Accumulation class shares don’t distribute dividends.
If you bought and held your PFICs, if you have PFICs that are Accumulation class shares, and if you don’t plan to permanently reside in the US, and if it is possible to amend the returns submitted, it may be worth investigating. This method, however, produces absolutely brutal consequences if you sell the holding while you are US tax resident.
(In context the words “while you are a US tax resident” actually mean “while you are a US person”.)