Tax Tip Tuesday: Exit Tax Early Warning Indicators: Are You Already a Covered Expatriate and Don't Know It?

Here's the thing most international tax articles won't tell you: by the time you walk into a U.S. embassy to renounce your citizenship or file Form I-407 to abandon your green card, your exit tax exposure is already fixed. There is no going back, no last-minute restructuring, and no do-over.

The exit tax under IRC Section 877A doesn't care when you start planning. It cares about what your financial life looked like on the day before you left. That's why identifying the warning signs early — sometimes years in advance — is the only way to have meaningful options.

This post breaks down the three tests that determine whether you are a "covered expatriate," the specific early warning indicators for each, and the scenarios that catch people off guard most often.

A Quick Primer: What Is the Exit Tax?

When a U.S. citizen formally renounces their citizenship, or when a long-term green card holder abandons or has their status revoked, the IRS applies what's known as the expatriation tax. Under IRC Section 877A, the government treats you as if you sold every asset you own worldwide — stocks, real estate, business interests, retirement accounts, foreign investments — on the day before your expatriation.

Any net gain above an inflation-adjusted exclusion amount gets taxed immediately at applicable capital gains rates, even if no actual sale occurred. For 2025, the exclusion amount is $890,000.

This is not a tax on selling your home or cashing out your 401(k). It is a tax on paper gains — wealth that still exists, that you still hold, that you have not yet converted to cash. That's what makes it so disruptive for people who see it coming too late.

Who Is Covered? The Three Tests

Not everyone who leaves the U.S. tax system owes exit tax. You are only subject to it if you qualify as a "covered expatriate." To be a covered expatriate under Section 877A, you must satisfy any one of three tests under IRC Section 877(a)(2). Meeting just one is enough.

Test 1: The Net Worth Test — And Why $2 Million Is Closer Than You Think

The net worth test looks at whether your worldwide net worth is $2 million or more on the date of expatriation. This threshold is not adjusted for inflation. That last part matters. The $2 million threshold was set in 2004 and has never moved. Meanwhile, asset values — particularly real estate — have risen dramatically.

While many years ago $2 million would have been a very large amount of money, many taxpayers who purchased a home several years ago in areas such as Southern California or Northern California may have seen the value of their home grow exponentially, making them covered expatriates based on the equity in their home alone.

Early warning indicators for the net worth test:

• Your primary residence has appreciated significantly and your equity is substantial. In markets like Los Angeles, San Gabriel Valley, and the Bay Area, a home purchased two decades ago may now carry $1.5 million or more in equity on its own.

  
  

• You hold retirement accounts — IRAs, Roth IRAs, 401(k)s — that count toward net worth even though you haven't touched them.

  
  

• You own interests in closely-held businesses, LLCs, or S corporations that carry unrealized value on the books.

  
  

• You hold foreign real estate, foreign brokerage accounts, or stakes in foreign entities.

  
  

• You have appreciated stock portfolios — particularly concentrated positions or employer stock you've held for years.

  
  

• You have cryptocurrency that has appreciated substantially since purchase.

The calculation: Net worth is assets minus liabilities. Net worth includes real estate, investments, retirement accounts, businesses, and other assets minus liabilities like mortgages, loans, and credit card debt. If you own high-value assets but also have significant debt, only the net value of your holdings counts toward the threshold.

One important nuance: cash does not trigger the deemed sale calculation (since there's no unrealized gain in cash), but it still counts toward the $2 million net worth threshold.

Test 2: The Average Annual Net Income Tax Liability Test — The Misunderstood One

The tax liability test looks at the individual's average annual net income tax obligation for the five years ending prior to the date of expatriation — not gross income, but the actual taxes owed. For 2025, the inflation-adjusted threshold is $206,000.

This is the test that catches the most sophisticated taxpayers off guard. The reason: they're looking at their income and not their tax bill. High earners who use the Foreign Earned Income Exclusion (FEIE) or significant Foreign Tax Credits (FTCs) to reduce their U.S. liability may fall well below the threshold, even with substantial earnings. But taxpayers with domestic business income, partnership distributions, capital gains events, or large bonuses may have higher U.S. tax liability than they realize.

Early warning indicators for the tax liability test:

• You've had one or more large capital gains events in the past five years — business sales, real estate dispositions, large stock liquidations.

  
  

• You receive substantial distributions from pass-through entities (S corporations, partnerships, LLCs taxed as partnerships) that flow to your personal return.

  
  

• Your income fluctuates year to year. One or two very high years can pull your five-year average over the threshold even if other years were moderate.

  
  

• You've exercised stock options or received large equity compensation in recent years.

  
  

• You are a high earner in a professional services field — medicine, law, finance, tech — with consistent six-figure federal tax liabilities.

Example: Over the past five years, your federal income tax liabilities were $155,000, $185,000, $230,000, $245,000, and $205,000. Your five-year average is $204,000 — just above the 2025 threshold. You would be a covered expatriate on this test alone, regardless of your net worth.

What about expats using the FEIE? Most expats who use the Foreign Earned Income Exclusion (FEIE) or the Foreign Tax Credit (FTC) reduce their U.S. tax liability significantly. Their average annual U.S. tax liability may be $0, meaning they would not be covered expatriates based on this test. This is a legitimate planning consideration, but it requires you to have been living and working abroad for the relevant five-year look-back period — not just in the year you leave.

Test 3: The Compliance Certification Test — The Silent Trap

This is the test that has nothing to do with your wealth. Even if you are broke, you will be labeled a covered expatriate if you cannot certify on Form 8854 that you have been 100% compliant with U.S. tax laws for the last five years. This includes filing all required tax returns, FBARs (foreign bank account reports), and information forms for foreign businesses or trusts.

The certification is made under penalty of perjury on Form 8854 (Initial and Annual Expatriation Statement). Failure to file Form 8854 triggers a $10,000 penalty and automatic covered expatriate status regardless of your net worth or income.

This means that a person of modest means — someone whose net worth is $500,000 and whose tax liability has been minimal — can still become a covered expatriate simply because they missed an international information return years earlier.

Early warning indicators for the compliance test:

• You hold or have held foreign financial accounts — bank accounts, brokerage accounts, investment accounts — outside the United States. Annual FBAR (FinCEN 114) and FATCA (Form 8938) reporting requirements may apply.

  
  

• You are or were an owner, officer, or director of a foreign corporation (Form 5471), a foreign partnership (Form 8865), or a foreign disregarded entity (Form 5472).

  
  

• You have received gifts or inheritances from foreign persons exceeding $100,000 in a year (Form 3520).

  
  

• You are a beneficiary or grantor of a foreign trust (Form 3520/3520-A).

  
  

• You have lived abroad for extended periods and are uncertain whether all required returns were timely filed.

  
  

• You have never filed a U.S. return despite having a filing obligation as a U.S. citizen abroad.

  
  

The compliance test is particularly important for "Accidental Americans" — individuals who hold U.S. citizenship through birth but have lived primarily outside the United States and may have unknowingly accumulated years of unfiled returns and missed information reporting.

The Consequences Most People Don't Anticipate

Beyond the deemed sale calculation, covered expatriate status carries two consequences that often get overlooked:

Retirement Accounts Are Fully Distributed — On Paper

Traditional IRAs, Roth IRAs, health savings accounts, 529 college savings plans, and Coverdell education savings accounts are treated as if fully distributed on the day prior to expatriation for covered expatriates. For 401(k)s and eligible pension plans, distributions are subject to 30% withholding at the time of distribution after expatriation. Decades of deferred growth can be taxed in a single year.

Your U.S. Family Members Pay 40% on Your Gifts — Forever

Under §2801, any U.S. citizen or resident who receives a gift or bequest from a covered expatriate after the expatriation date owes a tax equal to the highest estate or gift tax rate — currently 40% — on the full fair market value received. This obligation falls on the U.S. recipient, not the expatriate, and it applies indefinitely, even decades after expatriation.

This has significant multigenerational consequences. Even if there is no exit tax implication at the time of expatriation, future U.S. tax implications exist — especially if the covered expatriate plans on giving gifts to U.S. persons in the future.

The Green Card Holder Nuance: Are You Already Counting?

Green card holders often don't realize that the exit tax clock is already running.

You are a long-term resident if you were a lawful permanent resident of the United States in at least 8 of the last 15 tax years ending with the year you are no longer treated as a lawful permanent resident.

This means that if you've held your green card for eight or more of the last fifteen years and you voluntarily abandon it, the exit tax rules apply just as they do to a U.S. citizen. Departing in year seven avoids the threshold entirely. Waiting until year nine or ten — without planning — can create significant liability.

Also worth noting: for green card holders, the expatriation date is often when you formally terminate LPR status by filing Form I-407, though other termination pathways can apply. The tax consequences are fixed as of that date.

A Note on California Residents

Southern California clients face a layered issue. The federal exit tax under IRC Section 877A is separate from California state tax.

If you are a California resident at the time of expatriation, your California-source income and capital gains may still be taxed. Federal expatriation tax rules under IRC §877A are separate from California's treatment. You will still owe California taxes on gains from selling California real estate, even as a non-resident.

California's Franchise Tax Board is also aggressive about residency determinations. Clients who believe they have severed California ties may find themselves in a dispute over whether they were truly a California non-resident on the date of expatriation — which affects which capital gains are subject to California's 13.3% top rate in addition to the federal exit tax.

The Planning Window Is Before You File, Not After

Every meaningful exit tax planning strategy — managing net worth, timing income, resolving compliance gaps, restructuring asset holdings, spousal gifting — requires time. In most cases, effective planning requires two to five years of lead time before the expatriation date.

If your total net worth is close to or above $2 million, planning ahead by transferring assets before the date of expatriation is an option. If your spouse is a U.S. citizen, you can give them an unlimited number of gifts to significantly reduce your net worth without triggering gift tax. For non-citizen spouses, an annual exclusion applies.

If you have compliance gaps — missed FBARs, unfiled international returns, or unreported foreign accounts — IRS remediation programs such as the Streamlined Filing Compliance Procedures may be available. But these programs can only be used before you are already under examination and, importantly, before you have already expatriated.

The worst position to be in is one where you have already submitted your paperwork to the embassy, your expatriation date is fixed, and your options are gone.

Are You Seeing the Warning Signs?

If any of the indicators in this post apply to you — or to a client who is considering a permanent move abroad — now is the time to assess your exposure. Exit tax planning is entirely fact-specific, and the analysis needs to happen long before the consulate appointment.

At MKHS Tax Group, we help U.S. citizens and long-term residents evaluate their exit tax exposure, remediate international compliance gaps, and develop strategies before it's too late.📧 info@mkhstaxgroup.com