Navigating Taxes as an American Living Overseas
Many Americans who move abroad are surprised at how complex their tax filings become. While filing as a U.S. citizen living in the United States can be confusing enough, the difficulties multiply exponentially once you file as a U.S. expat. As you contemplate your upcoming tax filing as an American abroad, be aware of the following considerations.
#1 – Investing in foreign investment companies is a bad idea.
You’ve heard us say this before, but it’s worth stating again. U.S. expats should avoid investing in Passive Foreign Investment Companies (PFICs), because cost you it will. Any gains you earn in a PFIC are taxed as ordinary income, and losses cannot be used to offset gains. That means you will need to pay taxes on all gains with no opportunity to decrease your tax liabilities with losses.
In addition, when you make an investment gain, that gain is prorated over every prior year. Prior years are all taxed at the highest rate in the year an investment is held. You’re also charged interest on the tax you would have paid on gains from the time you held the investment until today.
Put simply, the United States taxes PFICs very punitively. To complicate matters even more, these investments require that an investor file IRS Form 8621, which is extremely time consuming and requires complex accounting to complete.
The bottom line? If you’re an U.S. expat, reconsider investing in PFICs.
#2 – If you’re working and earning in a foreign country, you’re likely able to exclude much of your income from U.S. taxes.
Thanks to the foreign earned income exclusion (FEIE), the foreign housing exclusion or deduction (FHE) and the foreign tax credit (FTC), most Americans abroad can avoid paying U.S. federal income taxes on their earnings, therefore reducing their overall U.S. expat tax bill.
Foreign Earned Income Exclusion
The FEIE is a special provision for U.S. taxpayers living outside the United States and its territories. In 2022, the FEIE allows individuals to exclude up to $112,000 or $224,000 for married couples filing jointly. The exclusion is only for foreign earned income, not passive income such as rental or investment income. To qualify, the taxpayer must meet two criteria:
- Have a foreign tax home (see #3 below); and
- Meet one of two additional criteria:
- The bona fide residence test – To meet the bona fide residence test, you must be a residence of a foreign country for an uninterrupted period that includes an entire tax year (January 1 through December 31 for calendar-year taxpayers). You may briefly visit the United States or other countries during the period of establishing bona fide residence, as long as you clearly intend to return to your foreign residence.Once you have established residency in a foreign country for an uninterrupted period that includes an entire tax year, the date of your bona fide residency begins with the first date of your residency and ends with the date you abandon your foreign residence.
- The physical presence test – The physical presence test requires that a taxpayer reside in a foreign country for a 12-month period, which can be any period of 12 consecutive months that includes 330 full days of presence in a foreign country. Taxpayers who qualify under the physical presence test for a partial year should carefully choose the 12-month period that allows them the maximum exclusion for the year.
Foreign Housing Exclusion
In addition to the FEIE, a taxpayer who qualifies for the FEIE can also exclude, or if self-employed deduct, the amount of their foreign housing expenses (less a base amount). The limit on this benefit varies depending on the taxpayer’s tax home.
Foreign Tax Credit
The United States offers U.S. expats dollar-for-dollar credits on the taxes they pay on foreign sourced income. You cannot use credits for income you have already excluded, nor should you switch between using the foreign earned income exclusion and the foreign tax credit. If you start and then stop using the foreign earned income exclusion, you must wait five years to use it again or apply to the IRS to begin using it again.
Important note – Even if you have zero U.S. income liabilities, you must still file taxes in the United States. U.S. taxes are based on citizenship, not place of residence, so even if you live outside the United States, you file annually. You cannot obtain any exclusions without filing for them.
#3 – It’s important to establish a “tax home.”
A taxpayer can only have one tax home at a time. Your tax home is the place of your main business or employment, regardless of where you live. Your tax home is the place where you are permanently engaged to work as an employee or self-employed individual. For tax purposes, your tax home is not necessarily the same as your place of residence. However, if you do not have a main place of business due to the nature of your work, your tax home may be the same as your place of residence.
For example, an international airline pilot has a tax home at his or her home base airport. A travelling salesperson who is not a resident or taxable in any other country will likely have a tax home at his or her employer’s main location. If you are travelling on business, you are away from your tax home.
#4 – Foreign bank accounts require additional filing.
If you are a U.S. expat, you likely have a bank account in your country of residence. If the aggregate value of all of your non-U.S. accounts exceeds $10,000 at any time during the year, you must file FinCEN Form 114, a Report of Foreign Bank and Financial Accounts (FBAR), with the Financial Crimes Enforcement Network (FinCEN). This filing is separate from your tax return.
You must also file IRS Form 8938, Statement of Specified Foreign Financial Assets, to report the value of all foreign assets if those assets exceed $200,000 on the last day of the year or $300,000 at any time during the year (for a single expat filer). This amount includes pension assets as well as any account over which you have signature authority (ex. business accounts). These thresholds double if you are married filing jointly.
Failure to file an FBAR is a minimum of $10,000 and can be as high as 50% of the account’s value, which can quickly wipe out your assets.
#5 – The tax obligations of owning foreign real estate are incredibly complex.
Many U.S. expats wish to purchase real estate in their new country of residence, either as a primary residence or to generate rental income. Before you take the leap, it’s important to understand the tax treatment of foreign real estate holdings.
- U.S. reporting requirements – Typically, the purchase of foreign property does not need to be reported on your U.S. tax return; however, if you rent out the property, you will need to file Schedule E to report your rental income. You may also need to file a Form 8858 for your ‘foreign branch.’
- Impact foreign exchange rates – Foreign exchange rates can have a big impact on the value of the property. A foreign mortgage in a foreign currency will have a value in U.S. dollars based on the current exchange rate. When you repay the mortgage, the value in U.S. dollars (i.e., the amount you pay taxes on) will vary from the actual value of the property. This could give rise to a taxable foreign exchange gain where the cost of repaying your mortgage falls in U.S. dollar terms.
- Selling Foreign Assets – Selling foreign real estate as a U.S. expat can be challenging. Be sure to keep meticulous records during the time you own the property, as you will need to provide significant documentation when you sell.
Factors to consider:
- If you sell your property for a gain, you will be responsible for paying taxes on that gain, just as you would if you were living in the United States. Any losses realized from the sale of personal property are not deductible. However, losses from business property (such as a rental unit) can be deductible up to the amount related to the business use of the home.
- If you used the property as your primary residence the entire time you owned it, you may be eligible to exclude up to $250,000 in capital gains (up to $500,000 if married filing jointly).
- If you rented the property at any time while owning it, any depreciation allowed or allowable during the rental period will be recaptured, resulting in higher capital gains when you sell.
Example – selling a depreciated asset:
Assume you purchased a property for $1 million and rented it out for 20 years while taking depreciation, which for simplicity adds up to $500,000. You then sell the property for $900,000 (a $100,000 loss). All of the depreciation is recaptured and you are responsible for paying U.S. taxes on a $400,000 capital gain, even though you didn’t actually make any money when you sold the property. This can be a surprising and potentially significant issue.
Feeling overwhelmed? Don’t be. Creative Planning International is here for you. We work with U.S. expats and cross-border families to help maximize their wealth and avoid costly mistakes, especially when it comes to U.S. expat taxes and investments. We understand the complex interaction of multi-jurisdiction tax and regulatory regimes and take into account currency, diversification and other portfolio considerations as we help you plan and invest for the future.
If you’re an American living abroad and could use some help navigating your U.S. expat tax strategy, request a meeting with a member of our team.