Taxes can be a confusing subject especially if you are a US expat. Unlike all the other countries (with exception of Eritrea), the United States taxes its citizens on their worldwide income regardless of where they reside. Here are the most important things you should know about taxes and your expat tax return when you move overseas.
The Unites States has a citizenship-based taxation system. It means that even if you live and work in a foreign country, you will be a taxpayer in that country as well as in the US. Many don’t even know about their obligations to the US until their foreign bank asks them to fill out US tax forms to declare and confirm their US tax status for the purposes of FATCA.
We get a lot of expat tax questions so we prepared a few things you’ll need to know about your expat taxes before you move abroad:
- You must file a US tax return while living abroad if your gross worldwide income is above the filing threshold.
- You might need to file a State Tax Return.
- Investing in PFICs, having a foreign trust or a foreign corporation will trigger additional filing obligations.
- Your foreign bank will share your income information with the IRS due to FATCA.
• The IRS offers credits, exemptions and deductions to lower your tax liability, so you might not have to pay anything at all!
How do taxes work for expats?
In short, the US tax rules for expats are much the same as for Americans living in the US (their worldwide income is subject to US income tax). However, the IRS offers a variety of tools that can bring your tax owing to zero if you live overseas.
As an American living abroad, you can enjoy an automatic 2-month extension to file (until June 15). A further extension until October 15 is available upon request. However, taxes due must still be paid by April 15 – failure to do so will result in late payment interest being charged from April 15.
Why does the US tax expats?
The US has citizen-based taxation, which means that if you have US citizenship or you are a permanent resident (Green Card Holder), your worldwide income is subject to US tax regardless of whether you live in the country or not.
Introduced in the late 1860s in order to raise funds for the Civil War, the US introduced a law that taxed US expats on their US-sourced income. Over time, more laws were introduced and foreign income became taxable in the US as well.
Do I have to pay taxes on foreign income?
Your foreign income is taxable in the US, which means you have to file your expat tax return if your annual income exceeds the filing threshold (see below). However, there are various measures that mitigate your tax liability such as tax treaties, totalization agreements, foreign tax credit, foreign earned income exclusion and more. Most of our clients don’t have to pay anything at all.
Americans Expats (green card or passport holders) have an obligation to file a U.S. federal tax return if their annual income exceeds one of the following minimum thresholds:
- Single: $12,400.
- Married Filing Jointly: $24,800.
- Married Filing Separately: $5
- For citizens declaring as self-employed: $400
- For the head of the family (head of household): $18,650.
How to lower your tax liability?
These are the two most common tools that US expats use in order to avoid double taxation.
- Foreign Earned Income Exclusion.
The Foreign Earned Income Exclusion allows expatriates to exclude the first $107,600 as of 2020 (this amount is subject to inflation each year) of their foreign earned income..
To claim the foreign earned income exclusion, expatriates must file Form 2555, and meet the requirements of the bona residency test or the physical presence test.
- Bona fide residence test – You must have qualified as a Bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year.
- Physical presence test – You must have been physically in a foreign country for 330 full days or more in 12 consecutive months.
Important: You must file the form 2555 in order to benefit from the exclusion.
- Foreign tax credit
The foreign tax credit allows expatriates to claim a US tax credit of $1 for every $1 of tax they have already paid in the host country. This may be a better option for expatriates who pay more income tax abroad than they should in the U.S. or those who receive passive (rather than earned) income.
All foreign tax credits are claimed on Form 1116, which must be filed with Form 1040.
How to calculate foreign tax credit? Click here.
What happens if you don’t report your foreign income?
You might get away with it for a while. Nevertheless, you must bear in mind that willful failure to disclose income and pay tax is a federal offense under the IRS tax code. Willful mistakes on your US expat tax return might cost you a lot and could even land you in jail.
For those wondering “How will the IRS find out?”
Financial institutions around the world must report certain information to the IRS including your account value. If it doesn’t match the income information you report on your expat tax return, you might invite an audit. Penalties are hefty and it might not be worth the risk.
You might also need to report your foreign bank accounts and assets yourself.
- Expatriates who hold more than $10,000 in total in foreign bank or investment accounts at any time during the year (e.g., 2021) must report all of their foreign accounts by filing a Foreign Bank Account Return, or FBAR. FBARs must be filed online with FinCEN by October 15. The FBAR is filed with the Department of Treasury.
• Expatriates who have more than $200,000 in foreign financial assets at any time during the tax year must also report them on Form 8938, which must be filed with their annual federal return.
What forms do expats need?
The most common forms used for US expat tax preparation are:
- Form 1040 – It’s the same form you would use if you lived in the US. It summarizes your income, subtracts deductions deriving to your adjusted gross income. The IRS provided detailed instructions on how to complete the form, here.
- Form 2555 (FEIE) – Foreign Earned Income Exclusion.
- Form 1116 – Foreign Tax Credit (FTC). If you are not sure which one would be more suitable in your situation, find out more about their differences here.
- FinCEN Form 114 (FBAR) – Foreign Bank Account Return;
- Form 8938 – Return of Specified Foreign Assets;
- Form 3520 – Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts;
- Form 3520A – Annual Information Return of a Foreign Trust with a U.S. Owner;
- Form 8833 – Disclosure of a Treaty Reporting Position;
- Form 5471 – U.S. Person Information Return for Certain Foreign Corporations;
Form 8621 – Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. If you want to know what is PFIC and form 8621, click here.
Do expats pay state income tax?
If you have state-sourced income (for example rental property) and the state taxes its residents, you will need to file the State Tax Return and be subject to its income tax. Some states don’t recognize foreign tax credit or foreign earned income exclusion, hence your income might be subject to the state income tax as well. Creating closer ties with a foreign country is not recognized by some states in order to become a non-resident.
If you live in a state that taxes its residents on their income, you might want to create closer ties with a no- income state before you leave. You would need to obtain a mailing address, driving license and register to vote.
Tax treaties offer benefits to expatriates.
Tax treaties have been signed between the United States and more than 67 countries, including most (but not all) of the popular destinations for expatriates. Tax treaties are essential for multinationals doing business in a jurisdiction where they may be exposed to double taxation of income, which significantly increases the cost of doing business. Under these treaties, U.S. expats are taxed at a reduced rate or are exempt from US taxes on certain items of income from U.S. sources.
If your host country does not have a tax treaty with the United States or does not cover a particular type of income, you are required to pay taxes like other U.S. citizens. If you are self-employed and reside in a country that did not sign a totalization agreement with the US, you will be subject to the self-employment tax of 15.3% despite using FTC and/or FEIE.
Note: Tax treaties have what is known as a saving clause, which reserves the right of the United States to impose a tax on expatriates as if a treaty were not in effect.