Living abroad as a US expat comes with many benefits – the opportunity to immerse yourself in a new culture and build new communities of friends and colleagues, all while exploring the world at large. And yet, along with all of these freedoms and experiences, comes potential frustrations as well.
Example: When it comes to filing US tax returns as an expat, you may find the rules and process to be overwhelming. Luckily, there are credits and other tax breaks that US expats can take advantage of to ease their tax burden. These tax breaks often even eliminate any taxes owed. Two of the biggest tax savings tools expats should know about are the Foreign Tax Credit (FTC) and the Foreign Earned Income Exclusion (FEIE).
If you’re a US expat, you’ll want to consider using both when filing your 2021 tax returns.
As expat tax day (June 15th) approaches, here’s everything you need to know about the FTC and FEIE, so you can decide which one is right for your financial situation.
How can the FTC and FEIE help lower your tax liability?
First, it’s important to understand the difference between tax credits and deductions. Tax credits allow you to reduce your income tax directly, in other words, lowering any taxes you might owe. And, if the credit is refundable, it can actually increase your tax refund. This is the case even if you haven’t paid US tax during the year. Non-refundable credits, on the other hand, can lower your tax bill, but won’t add on to your refund amount.
Deductions, on the other hand, reduce your taxable income. This lowers the amount the US will calculate your tax on, lessening or even eliminating your tax bill altogether.
As a US expat, both the FTC and FEIE can help reduce the amount of money you’ll owe the IRS in taxes. They can also prevent you from getting taxed twice – once by the country where you’re working or living and again by the US.
What is the Foreign Tax Credit?
The Foreign Tax Credit reduces your tax bill by one dollar for every dollar (or dollar equivalent using the foreign exchange rate) you’ve already paid in foreign taxes. This saves you from double taxation on the same income.
So, for example, let’s say you are a US expat living abroad in Bali and you make $60,000 per year. If you’ve already paid $10,000 in taxes to Indonesia, then you can claim the Foreign Tax Credit for the amount of $10,000 to directly reduce your US tax bill. As long as the US tax bill related to your income is $10,000 or more, your credit will be the full $10,000. In many cases, this credit will eliminate the need to pay US taxes altogether by wiping out your taxes owed – but you’ll still need to file and claim this credit first.
Beyond using foreign tax paid as a credit, you can choose to instead take the foreign tax paid as an itemized deduction. If you claim it as a deduction, it will reduce your US taxable income, which will in turn lower your tax bill. If you opt to take the FTC as a credit instead, it will directly reduce your foreign tax bill. In most cases, if you’re claiming the FTC, it will be more financially beneficial for you to claim it as a credit.
You can only claim the FTC on foreign-sourced income taxed by provincial, local, or national governments. You can’t claim credits for taxes paid for foreign real estate tax, value-added tax (VAT), sales tax, social security, or property tax.
Who can claim the FTC?
You can only claim the FTC if you are a US citizen or taxpayer who earned and paid taxes on foreign income or other profits. Additional requirements include:
- – The foreign country must have imposed taxes on your income
- – You have already paid the tax or it has accrued (ie it’s due in the future based on income already earned)
- – You did not profit from paying the foreign tax
- – The US has not sanctioned the country to which tax was paid
Who should claim the FTC?
If you’re a US expat, a few situations where it’s advisable to claim this credit are if you…
- – Pay higher taxes in the country where you live than you would in the US: In this case, claiming the FTC typically will end up eliminating any US tax you might otherwise owe.
- – Have passive income streams earned outside of the US: You can apply the FTC to active and passive sources of income, including rental income, pensions, and investments from foreign countries.
- – Have dependents that qualify for the Child Tax Credit: As long as you have a child who is a US citizen and legally your dependent, you can qualify for a refundable CTC.
- – Want to contribute to an IRA: If you claim the FTC as a credit, and not a deduction, it won’t lower your earned income, which in turn allows you to contribute more to an IRA.
A Bright!Tax CPA can help you determine if the FTC makes the most sense for your financial situation.
What is the Foreign Earned Income Exclusion?
The other tax exemption you should consider as a US expat is the Foreign Earned Income Exclusion or FEIE. This tax break is more widely known than the FTC and can also help you reduce your US tax bill by reducing your taxable income. Like the FTC, it will prevent double taxes on your income – but may not make sense for all US taxpayers living overseas.
The FEIE works by lowering the amount of US taxes you’re on the hook for paying, by allowing you to exclude all or some of your foreign earned income from your tax return. Your foreign income must be from earned income including salaries, wages, bonuses, or commissions – you cannot exclude passive income.
For 2021 taxes, you can exclude up to $108,700 in earned foreign income through the FEIE; the 2022 threshold for the FEIE is set at $112,000. This then reduces your taxable income, lowering your US tax bill, and in some cases, may actually eliminate it altogether.
So, for example, if you’re a US expat who earned $80,000 in foreign income last year and made no other money – you could end up with a $0 tax bill. That’s because your income is under the threshold, so you’re able to exclude it all from taxation.
Who can claim the FEIE?
In order to qualify for the FEIE, the IRS requires that you pass either the Bona Fide residence test or the physical presence test:
- – You can prove that you are a bona fide resident of another country: In this instance, if you’ve established residency in a foreign country for an entire tax year, you can claim this deduction. For example, if you traveled to Cape Town at the end of 2020 and became a resident before the beginning of 2021, you could claim the FEIE on your 2021 taxes. This applies if you’re a US citizen or resident alien.
- – You were outside of the US for 330 days or more: This stipulation requires you to be outside of the US for at least 330 during twelve consecutive months. For example, if you traveled throughout Europe and Asia for most of 2021, and were only in the US for 15 days this year, you would fulfill this requirement.
Who should claim the FEIE?
The FEIE is a great way to save money on your taxes, but how do you know if it’s right for you? Here are some instances where it can make sense to claim the Foreign Earned Income Exclusion:
- – You do not pay foreign income tax: In this instance, claiming the FEIE is the best way to ensure you get the biggest tax break possible.
- – Your foreign taxes are lower than the US tax rate: If you pay less taxes abroad than you would in the US, the FEIE is typically the better option.
- – You’re on an IDR for a US student loan: This exclusion can benefit US expats with student loan debt tremendously. Loan servicers base your US income-driven repayment plans for federal student loans on the amount of income reported on your US taxes. If you claim the FEIE, it could reduce your adjusted gross income to as little as $0, which could eliminate your monthly student loan payments. Even if your AGI is higher than $0, your repayment requirements could still drop tremendously.
- – You’re claiming the stimulus payments from 2020 or 2021: If your income exceeded the threshold for obtaining Economic Impact Payments for COVID, you might still receive your full stimulus payment while claiming the FEIE, as it reduces the income used to evaluate whether you qualify.
If you’re not sure if you qualify for the FEIE, you can use the IRS’s interactive tax assistant tool or chat with a tax professional at Bright!Tax.
Which is best for you, the Foreign Tax Credit and the Foreign Earned Income Exclusion?
While both the FTC and FEIE can help lower your US tax bill, choosing the best tax exemption for your financial situation is important – choosing the wrong one could lead to you paying more taxes than you owe.
In general, at Bright!Tax, we recommend checking to see if you can apply for the Foreign Tax Credit first, for a few reasons. First, you can apply this credit to active and passive income streams, which can help reduce your tax burden comprehensively. Secondly, the stipulations for the FTC are less stringent than the FEIE – you don’t have to limit your US travel unless you’re earning income there. On top of this, you can carry any unused tax credit from the FTC forward and apply it to your next 10 years of tax returns or carry it back to your previous year’s taxes.
Perhaps most importantly, the FTC offers more flexibility for the majority of US expats. Once you claim the FEIE, you’ll need to claim it each year. If you decide to instead claim the FTC, you’ll need to revoke the FEIE. You’re then locked out of claiming it for the next five years.
For example, if you claim the FEIE for your 2020 taxes and decide to discontinue using the FEIE in 2021, you’re then prevented from claiming the FEIE for your next five tax returns.
Of course, everyone’s situation is different and depending on your financial situation, you may only be eligible for one of these two credits. For example, if you don’t pay foreign taxes, you can’t claim the FTC, so you should claim the FEIE in this case. Likewise, if you earn income sourced in the US, even if you pay foreign taxes on it, you cannot claim the FTC.
Here’s a quick comparison of when we recommend using each tax exemption:
|Consider claiming the FTC if…||Consider claiming the FEIE if…|
|You earn passive income||You do not pay foreign taxes|
|You pay foreign taxes at a higher rate than US taxes||Your foreign tax rate is lower than the US tax rate|
|You want to contribute to an IRA||You’re on an income-driven repayment plan for your federal student loans|
|Your dependents qualify you for the Child Tax Credit||You qualify for the stimulus relief payments from 2020 or 2021|
|You spend more than 35 days in the US each year||You do not qualify for the FTC|
The good news is, you don’t have to figure this out on your own. Bright!Tax can help you figure out which foreign tax break will save you the most money.
Can you claim both the Foreign Tax Credit and Foreign Earned Income Exclusion?
Yes, it’s possible to claim both tax exemptions, but not on the same income. It’s actually quite common – especially when people earn more than the FEIE threshold.
For example, if you’re a US expat whose foreign tax rate is lower than the US rate, you might opt to claim the FEIE for the income you earn abroad. You could then claim the FTC for any passive income you earn, such as from rental properties or other investments. This strategy may maximize the amount you’ll save on your US tax bill.
How do you claim the FTC or FEIE?
You can claim both the FTC or FEIE when filling out your tax returns.
The Foreign Tax Credit is filed with IRS Form 116 and the Foreign Earned Income Exclusion with IRS Form 2555. You can submit these forms electronically or by mail with your Form 1040.
If you need help filing a return, understanding the difference between the FTC and FEIE, or have other tax questions, reach out to an expert CPA at Bright!Tax.
When do I have to file my taxes?
If you reside abroad as of tax day 2022, as a US expat, you receive an automatic two-month extension to file your tax return. While US residents had to submit their 2021 tax returns on April 18th of this year, your tax return is due on June 15. If you still need more time to file, you can request an extension, which will extend your due date to October 15, 2022.
You can give yourself a little extra time to decide which tax exemption is best for you, by filing an extension with IRS Form 4868. You can mail this form directly to the IRS or work with your tax preparer or software service to submit it electronically.
And, if you realize you need even more time to get your tax documentation in order, you can send a written request to the IRS asking for an additional extension, moving your tax due date to December 15, 2022.
Can I claim the FTC or FEIE if I did not file my taxes last year?
Are you a little behind on your US taxes? Don’t panic. Thanks to the IRS Streamlined Procedure, catching up on past tax returns is simpler and less stressful than in the past. You can file three past-due tax returns via this process if you’re a US expat who has been out of the US for at least 330 days during one of these delinquent tax years. To take advantage of this process, you’ll also need to certify not filing was a result of non-willful conduct (for instance, you didn’t know you owed the US a tax return). The IRS also must not have contacted you about these returns first.
If you qualify for the Streamlined Procedure, you can also claim the Foreign Earned Income Exclusion and Foreign Tax Credit for the tax years submitted.
Bright!Tax can help you find the best tax breaks
While both the FTC and FEIE are great options for reducing your tax bill as a US expat, they’re just the start of the tax credits and exemptions you can apply to your 2021 tax return. Bright!Tax CPAs are experts in US expat tax and can help you minimize your tax liabilities, so you don’t end up paying more than you should..
Talk to a Bright!Tax CPA today to claim the Foreign Tax Credit or Foreign Earned Income Exclusion and make filing your tax return quick and painless.