Foreign Investment Tax & Reporting: a Guide for US Expats

Many Americans living abroad get the opportunity to acquire foreign investments at some point in their fiscal journey. While investing in financial vehicles outside of the US can play an important role in diversifying your portfolio and aligning your investment strategy to the economy of your host country, it’s important to understand how foreign holdings are treated when reporting to the US government. 

Of course, there are many different types of foreign investments, each with distinct rules and regulations.

Unfortunately, filing requirements for expats are often more complex than they are for Americans living stateside due to laws that aim to prevent offshore tax evasion. But for the everyday taxpayer investing abroad, with no intention of tax evasion, a comprehensive understanding of how the IRS treats foreign investments remains critical to both maintain compliance and also to build a portfolio that is tax efficient, despite your unique risk of double taxation as an American living abroad. 

The good news? As a tax firm specializing in US expat taxes, we’re confident and experienced with the tax and reporting implications of foreign investments. Below, we’ll walk you through a few of the most common foreign investment types, how to estimate the tax they’ll attract, which forms to report them on, and more.

What are foreign investments for US tax purposes?

The US government considers financial investments made by American individuals, corporations, partnerships, or trusts in non-US-based entities, assets, or financial instruments to be foreign investments.

A few of the most common types of foreign investments include:

• Stocks: Shares of ownership in a publicly traded non-US company
• Bonds: Debt or “IOUs” from a foreign government or corporation you’ve lent money to, promising the return of your principal investment plus interest 
• Pooled funds: Collections of multiple investments, including shares of companies, goverment or private bonds or real estate funds. Examples of pooled funds include mutual funds, exchange-traded funds (ETFs), and many pensions, among others.

• Real estate: Foreign property you purchase with the intention to generate income. Examples may residential rental properties, vacation rentals, undeveloped land, office parks, storefronts, etc. A primary or secondary residence is not considered an investment for US tax purposes
• Deposit accounts: While less common, interest-bearing deposit accounts held in foreign banks can be considered foreign investments.
• Foreign businesses: For US taxpayers who own or operate a business in another country, the ownership in the business itself may, in some cases, be considered a foreign investment.

Calculating tax liability on foreign investments

The US government applies taxes on foreign investments in various ways, depending on factors such as the type of investment, how long it’s been held, its value, etc.

Here are a few of the most important tax implications to keep in mind. 

Capital gains taxes on foreign investments

Capital gains refer to the profit you receive for selling an asset at a higher price than what you paid for it. There are two different capital gains tax rates, depending on how long you’ve held the assets before selling:

• Short-term capital gains: Assets sold after being held for one year or less are subject to short-term capital gains rates. These rates are the same as ordinary income tax rates: 10% to 37%, depending on your overall taxable income 
• Long-term capital gains: Assets sold after being held for over a year are subject to more favorable long-term capital gains rates. These rates are either 0%, 15%, or 20%,  depending on your overall taxable income

An additional net investment income tax may apply to those who earn over $200,000 per year. This 3.8% tax applies to investment income such as dividends, capital gains, and rental income, among others.

For US expats, this can be particularly problematic as they may already be paying taxes on this income in their country of residence. The NIIT essentially creates an additional layer of taxation that can’t be mitigated through typical expatriate tax strategies.

As a result, high-earning expats with significant investment income may need to consider alternative investment structures or seek specialized tax planning advice to minimize their overall tax burden.

Dividend income from foreign investments

The US government taxes dividends in one of two ways, depending on whether they’re nonqualified or qualified. Nonqualified dividends incur ordinary tax rates (10% to 37%), just like short-term capital gains. Qualified dividends tax rates, on the other hand, mirror those of long-term capital gains: 0%, 15%, or 20%, depending on overall income. 

To count as qualified, dividends must meet certain criteria, such as:

• Originating from a US corporation or qualifying foreign entity
• Counting as true dividends, i.e. payments from a company’s share of profits to its shareholders
  • Note: This does not include insurance premiums, credit union distributions, or payments from co-ops or other tax-exempt organizations
• Being held for long enough (typically more than 60 days)

Since by definition, foreign dividend income isn’t coming from a US corporation, the corporation making the payment must be a qualified foreign entity.

Criteria for meeting the definition of a qualified foreign entity for corporations

A corporation must meet at least one of the following criteria:

• Be incorporated in a US possession (such as Puerto Rico, Northern Mariana Islands, American Samoa, Guam, or US Virgin Islands)
• Be traded on an established US securities market
• Be eligible for benefits from a US income tax treaty
  • Note: To be eligible for US income tax treaty benefits, a foreign corporation must typically be:
    • A tax resident of a country that has an income tax treaty with the US, AND
    • Publicly traded, or the subsidiary of a publicly traded company, OR
    • Owned at least 50% by qualified tax residents of a country with a US tax treaty, with less than 50% of income going to nonresidents through deductible payments, OR
    • Actively engage in trade or business with the US, OR
    • Owned by entities that qualify for treaty benefits, OR
    • Headquartered in the US, OR
    • Granted discretionary determination by a relevant US authority

As you can see, foreign dividend payments must jump through many more hoops to receive the qualified dividend status. As a result, they are more likely to be nonqualified than qualified.

Passive Foreign Investment Company (PFIC) rules & tax implications

The US tends to tax foreign pooled funds (like mutual funds, investment trusts, ETFs, and even certain pension funds) much more harshly than domestic pooled funds. This is due to the variance between IRS regulations for these funds and those that foreign pooled funds are subject to abroad.

Say you invest $10,000 in a popular UK-based FTSE 100 index fund, unaware it’s classified as a PFIC. After 5 years, the investment grows to $15,000. When sold, instead of paying the expected 15% long-term capital gains tax on the $5,000 profit, you may face:

1. Ordinary income tax rates (up to 37%) on the gain
2. An additional interest charge for the deemed tax deferral
3. Complex reporting requirements on Form 8621

The total tax liability could potentially exceed the $5,000 gain, making what seemed like a straightforward foreign investment significantly less profitable than a similar US-based fund.

As a result, many tax and financial professionals will advise you away from adding PFICs to your investment portfolio.

Foreign-based pooled investment funds are considered Passive Foreign Investment Companies (PFICs) if:

• 75% of their gross income comes from passive sources like investments, OR
• At least 50% of their assets are held to produce passive income

PFICs can be taxed in one of three ways:

Excess distributions (aka. the default method)

The excess distribution method is applied if you do not elect one of the other two methods (which we’ll discuss below), and as a result, it usually comes with the harshest tax treatment. Under this method, US shareholders of PFICs defer taxes until they receive earnings or distributions from the investment or dispose of shares. 

Excess distributions are defined as distributions exceeding 125% of the average distributions received over the past three years, as well as any gains from the sale of PFIC fund shares. 

The US taxes excess distributions from PFICs using a complex method that allocates the distribution across the entire holding period. The portion allocated to the current year and pre-PFIC years is taxed at current ordinary income rates (10% to 37% for individuals).

The portion allocated to prior PFIC years is taxed at the highest ordinary income rate for each of those years. Additionally, an interest charge is applied to represent the value of tax deferral, potentially resulting in a total tax burden that can exceed the actual distribution received.

For long holding periods, you can end up owing as much as 100% in taxes — rendering the investment largely worthless.

This heavily punitive tax ultimately penalizes foreign pooled investments that do not distribute at the pace that US-regulated pooled investments are required to by applying the highest tax rate and interest to funds that, from the IRS perspective, are delayed distributions and should have been subject to tax on the IRS return at an earlier date.

The calculation to arrive at accurate excess distribution reporting is extremely complex, and if the heavy PFIC tax on your investment doesn’t turn its return upside down, the time and cost related to tax preparation may drive you to seek alternative investments.

Market-to-market

One way to avoid the heavy tax and complicated exercise of the default excess distribution method is to elect market-to-market treatment of your PFIC investments on Form 8621.

Under this method, you will pay taxes at ordinary tax rates (10% to 37%) on any annual increase in the fair market value of your investment. While your gains will not have been realized yet, if the value decreases after you previously declared a gain, you can then claim an ordinary loss.

Qualifying electing fund

A final option for PFIC reporting is the qualifying electing fund taxation method, elected again on Form 8621.

Under this taxation method, you’ll pay taxes at ordinary rates (10% to 37%) on your share of PFIC-related income, capital gains, and distributions over the year. This method is less frequent than others, as it requires the foreign fund to provide detailed information about its ordinary earnings and net capital gains to the US shareholders annually.

Rental income

From a tax perspective, the US government treats rental income on foreign properties largely the same as rental income on domestic properties. It classifies foreign rental income as ordinary income and taxes it at ordinary rates (10% to 37%).

Deductions that are ordinary and necessary for the production of rental income can be taken to offset rental income.

Furthermore, you can claim depreciation on foreign rental properties to reduce the amount of net income you report and, therefore, the taxes you pay. It’s worth noting that depreciation on foreign rental properties is calculated over 30 years vs. 27.5 years on domestic rental properties.

Key tax forms for reporting foreign investments

Some of the forms you may need to use when reporting foreign investments and the income types associated with them include:

• Form 1040: For reporting individual income
  • Schedule B: For reporting interest income and dividends
  • Schedule D: For reporting capital gains and qualified dividends
  • Schedule E: For reporting royalties, rental income allowable expenses, and trust fund distributions
• Form 8938: For reporting foreign assets whose value exceeds $200,000 on the last day of — or $300,000 at any point during — the tax year (thresholds are lower for those based in the US)
• FinCEN Form 114: Also known as the Foreign Bank Account Report (FBAR). For reporting foreign bank and financial accounts whose combined value exceeds $10,000
• Form 8621: For reporting PFIC holdings and electing tax treatment
• Form 3520: For reporting:
  • Ownership of, or certain transactions with, foreign trusts
  • Receipt of gifts:
    • Exceeding $100,000 from a foreign person or estate 
    • Exceeding $18,567 in 2023 (or $19,570 in 2024) from a foreign corporation or partnership
• Form 4562: For calculating rental property depreciation
• Form 5471: For reporting foreign ownership of a foreign corporation

Important due dates & penalties for non-compliance

While the standard deadline for most of these forms is April 15th, Americans living abroad receive an automatic two-month extension until June 15th to file their individual tax return. They may extend this even further to October 15th by filing Form 4868 and once more to December 15th by sending a letter to the Internal Revenue Service (IRS).

However, expats must still pay any taxes associated with foreign investments by April 15th.

Failing to file the required forms can result in penalties that vary in severity depending on things like:

• Which forms you failed to file
• Whether or not your non-compliance was intentional
• How long you’ve gone without filing the required forms

Additional considerations for expats

A few other things expats should keep in mind when it comes to foreign investments include:

• Foreign tax implications: Besides the US, you may owe taxes on foreign investments to your country of residence and/or the country/countries where those investments are based
• Currency conversion: When reporting foreign investments on US tax forms, you must always convert the value into US dollars using an IRS-approved exchange rate
• Receiving tax forms: While US-based financial institutions must give you tax forms associated with investments (such as 1099-DIV), foreign ones don’t. They may provide you with equivalent forms — but even if they don’t, you must report that information on your US income tax return
• Professional assistance: Given the many different (and often complex) tax implications and reporting obligations of foreign investments, you may be better off working with a licensed tax professional

Strategies to minimize the tax burden of foreign investments

A few ways you may be able to minimize the tax burden of foreign investments include:

Choosing the right investment vehicles

Given the different taxation methods for foreign vs. domestic investments, expats should consider each investment vehicle carefully before moving forward. For example, the US government’s harsh tax treatment of PFICs and complex reporting requirements for them lead many Americans to avoid investing in foreign pooled funds entirely. 

On the other hand, the following foreign investments are fairly safe from a US tax perspective:

• Stocks (excluding pooled funds like mutual funds, index funds, or ETFs)
• Real estate
• Government bonds
• Interest bearing accounts

Timing of investment sales & purchases

Timing the purchase and sale of your investments carefully can also help you minimize the tax liability of foreign investments. Holding assets for over a year before selling them, for example, can qualify you for the more favorable long-term capital gains rate. Doing so can help you reduce your capital gains taxes by up to 17%. 

Claiming tax treaty benefits

The US has income tax treaties with dozens of other countries, all of which help nationals of one country living in the other avoid double taxation — at least in theory. 

Unfortunately, most of these agreements contain a saving clause that gives the IRS the right to tax Americans as if these agreements didn’t exist at all. The good news? Most tax treaties exclude certain provisions from the saving clause, allowing those benefits to survive. 

For example, a surviving provision in the US-UK tax treaty allows US expats living in the UK to make a one-time, tax-free lump sum pension withdrawal up to 25% (maximum of £1,073,100, or roughly $1,395,572). Furthermore, some treaties provide additional benefits to individuals studying or working in education or recipients of passive income.

To claim tax treaty benefits, you’ll file Form 8833.

Leveraging the Foreign Tax Credit (FTC)

If you owe taxes on foreign investments to a country other than the US, the Foreign Tax Credit (FTC) can be an incredibly valuable tax break. The FTC gives you dollar-for-dollar US tax credits for any foreign income taxes you pay, which you can apply to your US tax bill. Essentially, this lets you subtract your foreign income taxes paid from the US income taxes you owe.

To be eligible for the FTC, foreign taxes must be:

• Legal
• Based on income
• Due by you specifically
• Paid or accrued

You can claim the FTC by filing Form 1116.

Make Bright!Tax your trusted tax partner

While foreign investments can play an important part in reaching your personal financial goals, they have complex tax and reporting obligations you shouldn’t lightly. To optimize your tax strategy and stay compliant, it’s best to work with a licensed tax professional specializing in US expat taxes — like the CPAs at Bright!Tax.

Resources:

1. Qualified and Nonqualified Dividend Tax Rates
2. Foreign Dividends & U.S. Income Tax
3. Eligibility for Treaty Benefits Under the Spain-U.S. Income Tax Treaty
4. Passive Foreign Investment Companies
5. Passive Foreign Investment Company (PFIC) Rules