Nonresident Aliens, 'Covered Expatriates,' and the §121 Principal Residence Exclusion

By Thomas S. Bissell, CPA

Celebration, FL

Because of the sluggish U.S. housing market, resident aliens who
move out of the United States are finding it increasingly difficult
to sell their U.S. principal residence at an acceptable price
before they move - with the result that the sale often takes place
after the owner has once again become a nonresident alien for U.S.
income tax purposes. If there is gain on the property when it is
eventually sold, the question arises whether the exclusion of up to
$250,000 for each spouse under §121 may be claimed, or whether the
Foreign Investment in Real Property Tax Act (FIRPTA) rules of §897
will apply instead so as to deny the §121 exclusion.

A different but related problem arises under the
anti-expatriation rules of §877A. If a U.S. citizen or "former
long-term resident" gives up his citizenship or permanent residence
visa (green card) and the mark-to-market rules apply with respect
to the individual's worldwide assets,1 may the §121
exclusion be claimed so as to exclude part or all of the gain on
his principal residence from tax? Whether the exclusion is
available or not, what rules apply subsequently if and when the
home is actually sold?

Section 121 was amended in 1997 to replace the former "rollover"
provisions of §1034, as well as the rules of former §121 that
limited the taxable gain on the sale of a qualifying principal
residence to $125,000 for individuals age 55 or older. Although
§121 contains a number of detailed provisions, the two principal
requirements are that the taxpayer have owned and
occupied the property as his principal residence for
at least two of the five years prior to sale. The maximum amount of
the exclusion is $250,000, although a married couple filing a joint
return may exclude up to $500,000 of the gain (even if only one of
the spouses is the owner of the property).  Because of the
two-out-of-five-year test, technically the property may qualify for
the exclusion if it is owned and occupied by the taxpayer for two
years and then rented out (and/or is left vacant) for up to three
years prior to the date of sale.

If a resident alien moving out of the United States has owned
and occupied a U.S. property as his principal residence for at
least two years, and if he sells the property at a gain within
three years thereafter after having become a nonresident alien, up
to $250,000 of the gain will typically be excluded if the §121
exclusion is available.  The question arises, however, whether
the broad gain recognition rules of §897 will "trump" §121. When
§121 was amended in 1997, there was considerable confusion among
international tax practitioners as to whether this would happen.
Although §897(e) provides for an exception to the FIRPTA gain
recognition rules where the gain on a United States real property
interest (USRPI) is exchanged for another USRPI pursuant to a
nonrecognition provision of the Code, Reg. §1.897-6T(a)(2) has
provided since the 1980s that the §121 exclusion is not a
"nonrecognition" provision2 - thus implying that
the gain would be taxed if the seller were a
nonresident alien. However, in 2002, the FIRPTA withholding
regulations under §1445 were amended in proposed form, and then
finalized in 2003, to provide that a nonresident alien who believed
he qualified for the §121 exclusion could apply to the IRS for a
withholding certificate in order to avoid 10% withholding on the
gross proceeds at the closing (provided that the alien furnished
the IRS with information to the effect that he satisfied the
ownership and occupancy requirements of §121).3
Although a conforming amendment to the §897 regulations themselves
would have been helpful, the strong language in the §1445
regulations is an indication that the IRS did in fact resolve this
issue in favor of the nonresident alien.

Anecdotal evidence also suggests that tax return preparers
routinely claim the §121 exclusion - whether or not the nonresident
alien has obtained an IRS withholding certificate exempting the
sale from §1445 withholding tax4 - and it does not
appear that the IRS has issued any published or private rulings
denying the exclusion.  Although the IRS also does not appear
to have published anything that specifically allows the exclusion
(other than the language in the §1445 regulations), it does state
indirectly in Publication 519, U.S. Tax Guide for Aliens,
that an alien may claim the §121 exclusion in the appropriate
circumstances, with the exception of "nonresident aliens who are
subject to the expatriation tax rules" (discussed further below) -
thus implying that a nonresident alien who is not subject
to the expatriation tax rules is permitted to claim §121.5

If two married resident aliens anticipate moving abroad in the
future and selling their U.S. home at a gain that exceeds $250,000,
it may be prudent to make sure that the property is owned in joint
name.  If the home is owned by only one spouse, the exclusion
of up to $500,000 of gain may only be claimed if the couple files a
joint return for the year. If either or both of them are
nonresident aliens at the end of the year in which the sale takes
place, they must file married separate returns for the year, and
the result will be that only $250,000 may be claimed by the spouse
who owns the property. Even if the sale takes place while they are
still resident aliens, if the sale takes place in the same year
that they move abroad and if either spouse is a nonresident alien
at the end of the year, in most cases they must file married
separate returns for the year, with the same tax result. The only
way to avail themselves of the full $500,000 exclusion is to
jointly own the property. In that case, each of them could claim up
to $250,000 of gain on their separate tax returns. However, if
advance planning is done to place the property in joint name at
least two years prior to the expected sale date, the couple should
take steps to avoid the possible imposition of U.S. gift tax.6

As noted above, separate U.S. tax rules apply if an individual
abandons his U.S. citizenship or "green card" and becomes a
so-called "covered expatriate" who is subject to the mark-to-market
rules of §877A.In that situation
§877A(a) provides that all of the individual's assets (with certain
exceptions, including a $600,000 exemption amount that is adjusted
for inflation for the year 2014 to $680,000) are deemed to have
been sold on the day before he expatriates, and are subject to U.S.
income tax. It is unclear whether the §121 exclusion may be claimed
in doing this calculation, and the IRS has remained silent on the
issue since the enactment of §877A in 2008. In a recent report, one
of the American Bar Association committees on international
taxation states (without citation) that the §121 exclusion "is not
available to a covered expatriate subject to the mark-to-market
tax,"8 and recommends
that §877A be amended so as to provide an exclusion. It is true
that §121(e) provides that the exclusion may not be claimed by an
individual who is subject to the anti-expatriation rules of
"section 877(a)(1)" but, except in extremely rare situations, those
rules were replaced in 2008 by the very different provisions under
§877A. Thus, technically, §121(e) does not deny the exclusion for
purposes of §877A. In addition, it is clear that the FIRPTA rules
of §897 do not apply, because the mark-to-market gain is calculated
on a day on which the individual is still classified as either a
U.S. citizen or a resident alien, and §897 only applies to
nonresident aliens.

In considering this issue, therefore, one must fall back on the
language of §877A itself. Unfortunately, the language of
§877A(a)(2)(A) is troubling, because it provides that, in applying
the deemed-sale rule of §877A(a)(1), "notwithstanding any other
provision of this title, any gain arising from such [deemed] sale
shall be taken into account for the taxable year of the sale… ."
That language suggests that any exclusionary provisions are ignored
for this purpose - although it could possibly be argued that "gain
arising from such sale" might have to take into account any
exclusions that appear elsewhere in the Code.

If the deemed-sale rule of §877A does override §121, then the
basis of the property would be stepped up under the flush language
of §877A(a) by the amount of the taxable gain (minus the portion of
the $680,000 allowance that is allocable to it).9 If the property
is subsequently sold, any additional gain would normally be subject
to tax under the FIRPTA rules of §897, because it is likely that on
that date the covered expatriate will be a nonresident
alien.10 However, it is
arguable that the §121 exclusion should be available at that time
(if the ownership and occupancy requirements are met), because a
covered expatriate is treated for U.S. tax purposes like all other
nonresident aliens after the mark-to-market rule has been applied
to him. Of course, if the property is located outside the United
States - which will be the case with many covered expatriates - any
subsequent appreciation will usually be exempt from U.S. income tax
when the property is sold, because nonresident aliens are not
subject to U.S. tax on gains from foreign-situs real property.

On the other hand, if the correct answer is that the §121
exclusion is available to reduce or eliminate gain on the
property under the mark-to-market rule,11 presumably
the amount of the gain that is excluded (as well as any additional
gain that is taxed under the mark-to-market rule) is added to the
basis of the property. If the property is later sold, presumably
the §121 exclusion could not be claimed a second time with respect
to any subsequent appreciation in the value of the property, and as
a result the subsequent appreciation would be taxable under §897,
assuming the property is located in the United States. If the
property is located in a foreign country, however, any subsequent
appreciation would generally be exempt from U.S. tax when the
property is sold.

Because of the significant risk that a covered expatriate cannot
claim the §121 exclusion for purposes of §877A, one planning option
might be for the individual to sell the property prior to
expatriation to a relocation company or other third party. Although
the buyer might request some kind of a discount from the market
value of the property, the tax savings under §121 could be
substantial. As discussed above, however, if the taxpayer is
married and if the home is owned by only one of the spouses, the
couple might be limited to the $250,000 exclusion even if the sale
takes place prior to expatriation. This would occur if the covered
expatriate and/or his spouse is classified as a nonresident alien
at the end of the year.

Two final notes concerning income taxes other than U.S. income

1. State and local income taxes in the United States.
 In both of the situations discussed above - a sale by a
nonresident alien (who is not a "covered expatriate") and a deemed
sale by an individual who is a covered expatriate - always consider
the applicable state and local income taxes in the state where the
property is located (if the property is in the United States) and
in the state(s) where the property owner is or was resident.

2. Foreign income taxes. Always consider the potential
impact of income taxes under the laws of a foreign country,
especially if the property is located within the United States and
it is sold after the owner moves out of the United States. This
should be a particular concern for covered expatriates, because
most foreign countries are unlikely to treat the mark-to-market
rule of §877A as a taxable event under their income tax laws. As a
result, there would often be a risk of double taxation.

This commentary also will appear in the June 2014 issue of
 Tax Management International Journal.  For
more information, in the Tax Management Portfolios, see Bissell,
907 T.M.
, U.S. Income Taxation of Nonresident Alien
Individuals, Caballero, Feese, and Plowgian, 912 T.M.,
U.S. Taxation of Foreign Investment in U.S. Real Estate,
Klasing and Francis, 918 T.M., Section 911 and Other
International Tax Rules Relating to U.S. Citizens and Residents,
and in Tax Practice Series, see ¶7140, Foreign Persons -
FIRPTA, ¶7150, U.S. Persons - Worldwide Taxation.


  1 It should be noted that the number of individuals
who become subject to §877A each year (probably not more than a few
thousand) is vastly smaller than the number of individuals who
become nonresident aliens without the application of §877A
(probably in the tens of thousands).

  2 See Caballero, Feese, and Plowgian, 912 T.M.
(Bloomberg BNA Tax & Accounting), U.S. Taxation of Foreign
Investment in U.S. Real Estate
, at III.G.2. When the
regulation first became effective, §121 excluded only the first
$125,000 of gain from the sale of a principal residence by an
individual age 55 or older. However, the regulation was not changed
after the much broader provisions of §121 that apply today were

  3 Reg. §1.1445-3(b)(5).

  4 For example, many nonresident aliens might not
apply for a withholding certificate (either out of ignorance of the
law, or because of lack of time to obtain the certificate). In
addition, if the sales price is less than $300,000, and the
purchaser certifies that he will use the property as a "residence,"
no FIRPTA withholding is required under §1445(b)(5), and therefore
a nonresident alien seller has no need to apply to the IRS for a
withholding certificate. However, the fact that no 10% withholding
is done under §1445 (for whatever reason) does not mean that the
gain on the sale is exempt from tax under §897. In order for the
gain to be exempt from tax under §897, a statutory exemption must

  5 See IRS Pub. 519 (2013), at page
16. It should be noted, however, that Pub. 519 provides guidance to
both resident aliens and nonresident aliens.

  6 For example, if the property is initially
purchased by one of the spouses, and if 50% of the value of the
property is later transferred by that spouse to the other spouse,
U.S. gift tax could be imposed under §2523(i) on the value of the
gift to the extent that it exceeds $100,000.  The risk of U.S.
gift tax is less likely to arise if the property is initially
purchased in joint name, preferably with the downpayment being made
in the form of separate checks in equal amounts from each

  7 A discussion of the circumstances in which an
individual is subject to the §877A rules is beyond the scope of
this commentary. See Alden and Bissell, "The Increased Cost of
Expatriation: Is This the Final Chapter?" 38 Tax Mgmt. Int'l
429 (July 10, 2009), and Bissell, "An Exit Tax Enters the
U.S. Tax Lexicon - §877A and Guidance Under Notice 2009-85,"
Tax Mgmt. Memo. (Aprl. 12, 2010), at 123. 

  8 See "Options for Tax Reform in the
Inbound International Tax Provisions of the Internal Revenue Code,"
reproduced in The Tax Lawyer, Winter 2014, at 331. The
report is also available at

  9 If the covered expatriate is married but the
spouse is not also classified as a covered expatriate under §877A -
a situation that can occur under a number of fact patterns - the
mark-to-market rule would only be applied to the extent of the
covered expatriate's interest in the property. Thus, if the
property is held in joint name, in those cases only one-half of the
gain would be taxed under the mark-to-market rule of §877A(a).

  10 An individual who is a "covered expatriate" is
not automatically classified as a nonresident alien for U.S. income
tax purposes starting on the date after he expatriates. Thus, the
§7701(b) rules must still be applied in order to determine the
individual's residency termination date for the year. Unless the
expatriation date is on the last day of the year, however, in most
cases the covered expatriate will become a nonresident alien for
U.S. tax purposes at some point before the end of the calendar year
in which he expatriates.  It is assumed in most of the
discussion in this commentary that the covered expatriate will in
fact become a nonresident alien on the day after he

  11 As noted above, if the covered expatriate is
married and is a nonresident alien on the last day of the year, he
would only be entitled to claim an exclusion under §121 of up to
$250,000, because his nonresident alien status after the move would
require the couple to file married separate returns for the