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Living abroad can be an exciting adventure, filled with new cultures, experiences, and stories to tell to your grandkids.
But when tax season rolls around, that excitement can quickly turn into a cold sweat. US expats face unique tax filing challenges, and navigating the complexities on your own can feel like deciphering ancient hieroglyphics, which often leads to incorrectly paid or unpaid taxes.
This article unveils six common filing mistakes, along with clear explanations and strategies to steer you clear of trouble with the IRS. Let’s dive into ensuring a smooth (and hopefully penalty-free) tax filing experience, no matter where you live.
Copying a previous year’s return
Imagine this: You filed all your tax forms correctly last year. Feeling proud, you plan to reuse your winning strategy this year, but that may be a costly error. Here’s why: Expats often rely on their previous year’s filing as a template, assuming the rules stay the same.
Tax filing can be a complex process, and once you master it for one year, it’s tempting to think you’ve cracked the code forever.
What to do? Yearly updates to tax forms are a given. US tax laws are like a sneaky chameleon, constantly adapting with subtle changes, including inflation & changing tax laws. Before doing your calculations and submitting your forms, do research and check which updates that may impact your tax return in the current year.
Example:
Let's say you’ve filed everything accurately this year, including the FEIE (Foreign Earned Income Exclusion). This benefit allows you to exclude a portion of your foreign-earned income from taxation. For the 2023 tax year (taxes you’re paying this year), the exclusion amount increased to $120,000. It's projected to be even higher at $126,500 for the 2024 tax year—affecting the taxes you’ll be paying in 2025. To avoid this common mistake, it’s critical to keep the pulse on these subtle changes!
Reporting only US source income
Many expats mistakenly believe they only need to report income earned in the US on their tax return—but Uncle Sam has a different approach. The US requires expats to report their worldwide income, regardless of where it’s earned or taxed.
It’s a fair assumption and seems reasonable, as it’s the approach all but two countries in the world take to taxation. But the US sets itself apart by taxing the worldwide income of its citizens and permanent residents under a system called citizenship-based taxation.
What to do? FATCA (Foreign Account Tax Compliance Act) and other information-sharing agreements mean the IRS has a pretty good idea of your financial picture overseas. So, neglecting to report your foreign income can lead to hefty fines and penalties. Always report worldwide income on your US tax return, even if you’ve already paid taxes on it abroad. Don’t worry, tax benefits like the FEIE can help reduce or eliminate your US tax burden on that foreign income.
“Many a dual country couple innocently starts filing U.S. taxes together, and that can be a very costly mistake. 95% of married couples file joint tax returns, often as a knee-jerk reaction.” – Forbes
Example:
Say you earn $80,000 working in France this year. You also receive $10,000 in interest from a US savings account. Even though you paid French income tax on your salary, you still need to report both the $80,000 and $10,000 on your US tax return.
Incorrect claim for the Foreign Earned Income Exclusion
Expats often rely on the FEIE to save on US taxes, but claiming it incorrectly can lead to trouble. Here are some pitfalls that we see happen frequently:
- You choose the wrong benefit: While the FEIE excludes a portion of your income, the Foreign Tax Credit might be more advantageous depending on your situation.
- Your income doesn’t qualify for the FEIE: Not all income types qualify for the FEIE. Make sure you understand which income sources are eligible for exclusion.
- You have proof of residency issues: Expats often stumble on the Bona Fide Residence Test, either miscalculating their days abroad or failing to provide adequate documentation. Both errors can disqualify you from the FEIE, potentially leading to double taxation.
Note:
Filing independently can be tricky, and the FEIE has specific requirements. You might misunderstand the qualifications or overlook crucial details like income eligibility and residency proof, leading to claim denials and potential tax penalties.
What to do? There are a few things to do to ensure you avoid this mistake:
- Keep meticulous records of your time spent outside the US. There are two ways to qualify for the FEIE based on residency: spending a full calendar year in a foreign country or meeting the physical presence test (being outside the US for 330 days out of a 365-day period). Gather documentation that supports your chosen method.
- Make sure you understand the IRS guidelines. Generally, earned income from your job or business qualifies, while passive income like rental income or investments doesn’t.
- Consult a tax professional or research both benefits to determine which one maximizes your tax savings based on your income amount and the taxes you’ve already paid abroad.
Example:
Let's say you work remotely for a US company while living in Spain. You claim the FEIE on your income, but miscalculate your days spent in the US, exceeding the allowable limit. This could result in the IRS denying your FEIE claim, and you'd be liable for US taxes on that income you thought was excluded.
Incorrect tax filing status
Filing status matters—and married expats sometimes pick the wrong filing status on their US tax return. The decision between “Married Filing Jointly” or “Married Filing Separately” can be tricky and have long term consequences, especially those with a non-resident alien spouse.
Note:
Taxpayers with US citizen children and NRA spouses can also file as Head of Household. The advantages of filing as Head of Household are that you have higher income tax bracket thresholds, and also a bigger Standard Deduction.
What to do? Consider all your ducks in a row before making the call.
- Filing jointly: Filing jointly can be beneficial if your foreign spouse doesn’t have much income. This allows you to claim twice the standard deduction, potentially saving you taxes.
- Filing separately: If your spouse has a higher income or significant foreign assets, filing separately might be smarter. Filing jointly exposes all your income and assets (even future ones) to US tax liability.
Example:
Let's say you're an expat married to a stay-at-home spouse in Italy. Filing jointly could be a win-win. You'd get a bigger standard deduction and FEIE, potentially reducing your tax burden. On the other hand, if your spouse is a high-earning doctor in Italy, filing separately might be better to avoid US taxes on their income.
Missing items on your FBAR
Expats who have a total of over $10,000 in foreign bank and investments accounts at any time during the tax year are required to file a Foreign Bank Account Report (FBAR).
But many of them with foreign bank accounts have missed key details when filing this form. That’s not surprising, since figuring out which accounts need to be reported on an FBAR can be confusing.
What to do? Be aware of these hidden catches:
- It’s not just accounts directly in your name that need reporting. If you have signatory authority or any control over any foreign bank or investment account, like a business account, it needs to be included on your FBAR.
- Even accounts held in a trust or someone else’s name but benefit you in any way qualify for FBAR reporting.
Example:
Let's say you work in China and have a joint bank account with your business partner (a Chinese citizen). You also have a trust set up back home in the US that holds some investments. Since you have control over the business account and benefit from the trust, both would need to be reported on your FBAR, even though they aren't solely in your name.
When it comes to FBARs, don’t hesitate to be comprehensive. Don’t miss out on reporting any accounts that meet the criteria, even if they seem indirectly connected to you. Consult a tax professional if you have any doubts.
Not reporting anything beyond your salary
There is a myriad of filing requirements for expats relating to foreign assets, investments, interests in foreign corporations (whether minority or majority interests), trusts, and gifts from foreign nationals (including a foreign spouse), foreign trusts, companies, and foundations.
But, many expats think filing their salary is all they need to report on their US tax return—a big mistake. Expat tax requirements extend far beyond your regular paycheck.
What to do? Be aware of these additional reporting requirements:
- Foreign assets & investments: These include bank accounts, stocks, bonds, and even ownership in foreign businesses (whether a small share or majority stake).
- Trusts & gifts: If you benefit from a foreign trust or receive gifts exceeding a certain value from a foreign national (including your spouse), you need to report them.
- Foreign ties: Foreign trusts, companies, and foundations you’re involved with may also require reporting.
Example:
Let's say you're an expat in Thailand. You receive a salary, have a savings account in a local Thai bank, and own a small percentage of shares (above 10% when purchased or above 50% every year) in a Thai restaurant. You also benefit from a trust set up by your deceased aunt in the UK. In this scenario, you'd need to report your salary, the Thai bank account, your shares in the restaurant, and the income you receive from the UK trust on your US tax return.
BONUS: You misunderstand your tax filing requirements as an expat business owner
Sometimes, your LLC (Limited Liability Company) can become an IRS headache if you misunderstand the US tax filing requirements for your overseas ventures. Tax rules for expat-owned businesses can be complex, and the structure (LLC, corporation, etc.) can further complicate things.
What to do? Get clear on your tax filing obligations:
- Understanding your entity: The way your business is structured (LLC, sole proprietorship, etc.) and where it’s registered affects how its income is reported on your US tax return.
- Tax filing forms: Depending on your business structure and income level, you might need to file additional forms beyond your personal tax return.
Example:
Let's say you run a digital marketing agency as an LLC while living in Costa Rica. As an LLC owner, your business income is considered pass-through income and reported on your personal tax return. However, depending on your income level, you might also need to file additional forms to report your business activity and pay self-employment taxes.
