Americans who live outside the United States face a number of tax issues, like what financial accounts they need to report and which deductions and tax credits they may qualify for. Filing your taxes as an expatriate can get complicated, but it is possible to understand.
Expatriates Tax Summary:
- Americans declare their worldwide income on their US federal tax return.
- Expats can reduce their US federal tax through the foreign earned income exclusion or the foreign tax credit or both.
- Expats will likely need to report their foreign bank accounts, brokerage accounts, and other types of financial assets held at financial institutions located outside the United States.
- Expats need to figure out whether they are exempt from the health insurance mandate.
- Expats might need to file state tax returns.
Reporting Worldwide Income
American citizens and American resident aliens are subject to federal income taxes on all of their worldwide income with no regard to where they live or how they generated their income.
The worldwide income expatriates report on their tax return needs to be converted and presented in US Dollars. Furthermore, we report income generated in the calendar year. So expats will need to keep detailed documentation on the amount and type of foreign income they are receiving and what year they received it in.
Foreign Earned Income Exclusion and the Foreign Tax Credit
Americans are taxed on their worldwide income, leaving that income susceptible to double taxation — once in the country where the income was generated and again by the USA. To help mitigate against this double taxation, expats can look into claiming the foreign earned income exclusion and/or the foreign tax credit.
Under the foreign earned income exclusion, Americans can reduce how much of their foreign wages and self-employment income is subject to federal income taxes in the United States. The foreign earned income exclusion works by reporting your taxable worldwide income and then taking a deduction that offsets your tax liability. For the year 2017, expats can exclude up to $102,100 of their foreign earned income. (This maximum exclusion amount is indexed for inflation, and the annual figure can change each year.)
The foreign tax credit works differently, by reducing your tax liability in the US, based on the income taxes that you paid to a foreign country or countries.
Conceptually, the foreign tax credit is fairly straightforward. For example, suppose Barbara earns $100 of income in Germany, and she paid $25 of income tax to Germany on that income. Now suppose Barbara’s tax liability in the US on that same $100 of income is $33. In this situation, we could claim a foreign tax credit of $25 against her US tax, bringing the net amount of US tax down to $8. In this situation, Barbara is still paying $33 of income tax on her $100 of income, with $25 going to Germany and $8 going to the United States.
Expatriates can claim the foreign earned income exclusion, or the foreign tax credit, or a combination of both. In order to optimize these two tax breaks, your tax accountant will need to answer the following questions:
- Is the client’s foreign earned income above or below the maximum for the exclusion?
- Does the client have other types of income on which foreign tax has been paid — such as interest, dividends, rental income, and so forth?
- Is the foreign tax higher or lower than the US federal tax on the same income?
- Does the client qualify for the foreign earned income exclusion?
- Will the client qualify for the exclusion next year?
- What are the client’s plans for travelling and working in different countries?
- What are the client’s plans for investing and saving for retirement?
Some of these questions are to determine eligibility for the foreign earned income exclusion, which has stricter qualifications than the foreign tax credit, such as maximum days spent in the United States. For tax planning purposes, estimates of your future income and plans for travel can help your accountant figure out which tax breaks will be appropriate for this year and future years.
Disclosing Foreign Bank Accounts and Other Financial Assets
Income isn’t the only thing expats need to report. They might also need to tell the US government — not just once, but twice — about any bank accounts, investment accounts or other financial accounts held in foreign countries. This reporting is very specific. Here’s what to report:
First, if you have at least US$10,000 across all of your foreign financial accounts at any time during the year, then you will need to disclose your foreign financial accounts on a FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR).
If you have at least US$50,000 across all your foreign financial accounts, then you might also need to disclose your foreign accounts on Form 8938, Statement of Specified Foreign Financial Assets, when filing your tax return with the IRS.
While there is no tax impact associated with the FBAR or Form 8938, penalties can be imposed if a person does not file the disclosure as required. The penalty for not filing an FBAR starts at $12,459 for non-willful violations. Additionally, the penalty for not filing Form 8938 starts at $10,000. The IRS can waive penalties if a person can show that there was a reasonable cause for why these forms were not filed.
The important thing for clients to know about foreign disclosures:
- Clients will need to let their accountant know what is the highest balance in each of their foreign financial accounts.
- It’s important to avoid penalties. So be sure to review each year whether an FBAR or a Form 8938 needs to be filed.
Expats and the Health Insurance Mandate
Americans are required to have health insurance coverage. If someone is not covered by health insurance, they could be subject to a penalty called the Individual Shared Responsibility Payment. Depending on the circumstances, however, a person residing outside the U.S. might not be penalized.
To be exempt from the individual shared responsibility payment, the person must meet the following criteria:
- Be a U.S. citizen or resident alien
- And either
- Be physically present in a foreign country or countries for at least 330 full days during any consecutive 12-month period, or
- Be a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
American expats need to look at their health insurance options proactively each year. What we are looking for is whether a person will meet the criteria for being exempt from the health insurance mandate. For the years when a person meets the criteria, they won’t have to buy health insurance, unless they want to. For the years when a person does not meet the criteria, they will need to buy health insurance or find some other exemption from the health insurance mandate if they want to avoid the individual shared responsibility payment.
Expats Might Need to File a State Tax Return
There are situations when an expat might need to file a state return.
- Expats may need to file a state tax return as a part-year resident, especially for the years when they move into or out of a state.
- Expats with rental properties or businesses may need to file non-resident returns in states where their rental properties or businesses are located since income is still being earned in that state.
Four states have stricter rules for determining residency status for tax purposes: California, Colorado, New Mexico, and South Carolina. This impacts expats who will be working on foreign assignment for a relatively short period of time, such as a year or year and a half, and then moving back to their home state. In these situations, clients will want to review the rules for non-residency status to find out if there is an optimal way to plan out the timing of their relocations.
Living abroad comes with lots of new requirements for your taxes. We highly recommend getting professional help.
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