Crypto Market – Renunciation for Tax Avoidance
The cryptocurrency market has allowed for absurd gains over the last decade. Bitcoin has risen from ~ $1,000 in February of 2017 to a current price of ~$50,000 per token. This represents a 50X return on the asset in just over four years. Smaller projects have unleashed even larger gains in a shorter time frame. Luna was priced at $.50 in March of 2020. Its current price is $70. This represents a gain of 140X in just over a year. If an investor placed $20,000 into Luna in March of 2020, that investment would currently be worth $2.8 million.
The track records of Luna and Bitcoin are far from the only examples of stellar returns. The market is littered with similar gains if an investor can time their entrance and resist taking gains early. Young retail investors across the globe are playing the crypto market with hopes of financial independence. Large, established investment firms are slowly dipping their toes into the market as the gains become something they cannot ignore.
The crypto markets volatility, and accompanying gains, come with heavy tax implications in the United States. Previously, we discussed US taxation on crypto gains. Notably, the arduous requirements placed on crypto investors to comply with the internal revenue code. Those posts can be found at the following links:
Clarifying the Rules for Crypto Taxation (Part One)
Clarifying the Rules for Crypto Taxation (Part Two)
This post will focus on a very particularized area of United States tax law using cryptocurrency gains as a launching pad. In this post, we will look at the United States rules on taxing a person who renounces their citizenship and moves to a foreign country. The focus here is to provide guidance for those that hope to thwart capital gains taxes in the United States by moving abroad.
*Expatriation has a dual meaning in the United States. Expatriates are either 1) US citizens that work abroad or 2) former US citizens who have renounced. The latter definition of expatriation will be used throughout this post.
Benefits of Moving Abroad
Many young, retail investors dream of the freedom that comes with financial independence. A large net worth alleviates the requirement to live in a certain geographic location. If citizens are not dependent on a particular job for meeting their day-to-day needs, large cities are mostly unnecessary. The scope of potential places to live expands greatly, including areas outside of the United States.
The policies and economic climate of foreign countries have numerous benefits for a person with financial independence. The cost of living can be a fraction of the United States. The taxation system can be more appetizing, notably on capital gains. If the citizen does not have a nuclear family, the possibilities are endless.
Let’s take Vietnam as an example. Vietnam has extensive ex-patriation communities that provide safe areas to live. The landscape and scenery are gorgeous. The cost of living is a drop in the bucket compared to the United States – a person can live a very luxurious lifestyle for around $4,000 per month.
A person with no substantial ties to the United States (notably, family ties), can essentially retire in Vietnam with a couple of million dollars. If the person enters Vietnam with $2.8 million, they can live for 56 years in luxury before they would run out of money. That figure does not account for inflation or unforeseen large expenses, but the point is made. With a $20,000 investment in Luna in March of 2020, a 35-year-old US citizen can essentially retire in Vietnam today.
Expatriation as a Tax Plan
If a citizen sells their crypto assets in 2021, they owe US taxes on the gains made. Let’s assume the cryptocurrency was held for over a year. In that case, 20% of the gain would go to the government. The $2.8 million would become $2.2 million after taxes. The amount of time the money would last in our Vietnam example is cut to 44 years.
In response to this clear dilemma, many investors have discussed renouncing their US citizenship to avoid US taxation. After all, if they plan to live abroad, US citizenship only serves to take capital from their bank account and provide easier reentry in the future.
Though this phenomenon has been brought into focus amidst the chaos in the cryptocurrency market, this tax saving plan is not new. For decades, citizens have looked at renouncement as a means to avoid paying US taxes. In response, the United States has set up rules outlining the tax implications for expatriates.
26 U.S.C. § 877, 877(A) – Ex-Patriation to Avoid Tax
The internal revenue code set up rules and regulations for handling the assets and gains of former US citizens. Under § 877(A), the code outlines which expatriates are “covered” by the statute: 1) persons with an annual net income of over ~$170,000 for the five years preceding expatriation, 2) persons with a net worth over $ 2 million on the date of expatriation, or 3) a person that does not certify compliance with the tax code on Form 8854.
If the citizen meets any of the requirements outlined above, they are subject to § 877(A). A person with enough money to retire overseas is often going to meet the $2 million net worth standard regardless of their provable income over the preceding 5 years. If the standard is met, the code classifies the citizen as a “covered expatriate.” The IRS has stiff rules in requiring the expatriate to declare their status on Form 8854.
Under §877(A), an expatriate’s property is deemed sold for its fair market value on the day before expatriation. All gains arising from the fictional sale of the property must be accounted for on the expatriate’s tax return. The IRS rules allow the expatriate to exempt $737,000 in gains from the tax.
877(A) is a direct attack on using expatriation to avoid United States taxes. Let’s assume a taxpayer invested $50,000 in Luna in March of 2020 and sold their holdings in December of 2021. The taxpayer would have sale proceeds of $7,000,000 and a gain of $6,950,000. That gain would be taxed at the 20% rate as it was held for more than one year. The total tax liability would be $1,390,000. Their total post tax proceeds would be $5,610,000. If the taxpayer filed their returns, and paid the tax, they would have met their US tax obligations.
Now, let’s assume that same taxpayer decides to move to Vietnam, renounce citizenship, and sell the crypto asset after the move. This plan would seem to make sense on paper. The taxpayer would not have executed a taxable transaction until after expatriation. §877(A) would prevent the tax plan from being executed. If the taxpayer’s renunciation was accepted on December 5, 2021, the IRS would view their entire cryptocurrency portfolio as being sold on December 4, 2021. The tax implications are identical to the first example. The tax rules create a legal fiction to treat assets as sold just before the citizenship status changes.
A Leap of Faith
If a citizen wishes to leave the country after the gains occur, the expatriation tax will harness their tax liability. The only way to circumvent these rules is to renounce citizenship well before the gains take place. For example, let’s assume the taxpayer above renounces their citizenship in March of 2020. That person would likely not meet the net worth requirement for § 877(A). Additionally, the gains on the fictionally sold asset would be so small that payment would not be an issue.
However, that tax plan takes a leap of faith and belief that the crypto portfolio will produce the absurd gains localized to sections of the market. It is just as likely that Luna will be worth $.50 in 2021. This reality makes it an unlikely choice for those gaining new financial independence in the market.
The more we talk to people invested in cryptocurrencies, the more it becomes obvious that many view it as a means to early retirement. Many retail investors are already very lax on the reporting and taxing requirements in this market. There is an assumption that the anonymity of blockchain prevents the government from identifying gains. This assumption is a clear misstep, but it exists in a high percentage of investors nonetheless.
With the IRS beginning to focus on the lost money in the crypto market, it is important for all investors to stay current with the evolving tax regulations in this area. That includes understanding the implications of renouncing citizenship as a tax avoidance strategy. At the end of the day, unless the taxpayer wishes to renounce citizenship before the gains are made, the IRS is going to get their piece of the pie. This long standing tax avoidance strategy has been dissected by lawmakers and the advent of § 887(A) ensures a citizen cannot escape taxation by moving abroad.