Of the more than nine million Americans who live overseas, many of them only discovered that they are required to file U.S. taxes from abroad, reporting their worldwide income, after they had moved.
Millions of U.S. expats must also pay income tax in the country where they live, so the question arises of how to avoid paying taxes on the same income twice, in their country of residence as well as to Uncle Sam.
Some assume that a tax treaty between the two countries will prevent this, but in fact all of the around 100 tax treaties that the U.S. has with foreign countries protect foreigners living in the States, rather than American expats, with very few exceptions.
There are however other ways for expats to avoid paying taxes on the same income twice.
Is there a foreign income tax credit available for U.S. expats?
While expats who earn over $10,000, or just $400 of self-employment income, always have to file a federal tax return, when they file they can claim a foreign income tax credit against taxes that they’ve already paid abroad.
The credit is simply called the Foreign Tax Credit, and expats wishing to claim it must file form 1116 along with form 1040.
Because different countries have different tax filing deadlines, expats receive an automatic extension to file their federal return until June 15th to file, giving them time to file their foreign taxes first and so demonstrate to the IRS that they have done so and how much they paid when they file their U.S. return.
If they still need more time, expats can apply for a further extension until October 15th.
“If you paid or accrued foreign taxes to a foreign country or U.S. possession and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes.” – the IRS
The Foreign Tax Credit works by offering expats a $1 U.S. tax credit for every dollar of foreign tax that they’ve already paid abroad.
Is the Foreign Tax Credit the only and best way for expats to avoid double taxation?
The Foreign Tax Credit is a good solution to potential double taxation for many expats, including those:
– who pay at least as much foreign income tax as the U.S. income tax they would owe. If they pay less foreign tax on the other hand, they won’t be able to claim enough U.S. tax credits to nullify their U.S. tax liability, so it may not be the best solution. (If they pay more in foreign income tax though, they can claim excess U.S. tax credits which they can defer for future use).
– whose income is passively (rather than actively) earned, for example from rents, interest, royalties or dividends, as there are no other exemptions available for expats whose income isn’t actively earned.
Some expats whose income is actively earned may be better off claiming the Foreign Earned Income Exclusion on the other hand.
The Foreign Earned Income Exclusion allows expats to simply exclude the first around $100,000 (the exact figure rises a little each year) of their income earned while they are living abroad (and they must be able to prove that they live abroad in one of two prescribed ways) from U.S. taxation.
The Foreign Earned Income Exclusion can be claimed by filing form 2555.
Expats who aren’t sure which exemption to claim should consult with a U.S. expat taxes specialist.
How can expats who are behind with their U.S. tax filing catch up?
Expats who are behind with their U.S. federal tax return (or foreign account FBAR reporting) can catch up while claiming the best exemption for them and without facing any late penalties under an IRS amnesty program called the Streamlined Procedure.