US Taxes for Expats – A Complete Guide – 12 Steps to Success
Many Americans living abroad are unaware of or confused about their US tax filing obligations. The US tax system is unusual, as it taxes based on citizenship. Almost every other country either taxes based on residence (meaning only people living in that country have to file taxes there), or taxes based on income arising in that country, regardless of residence (this is known as a territorial based tax system).
The US on the other hand taxes all of its citizens on their worldwide income, wherever in the world they may live.
Filing from abroad is more complex than filing in the US though, as expats also have to claim exemptions or credits to reduce or in many cases eliminate their US tax bill. They may also have to report any foreign registered businesses, bank and investment accounts, and assets that they may have.
In this article, we present a complete guide to US filing requirements for expats in 12 steps, shining a light into the very depths of the US expat tax maze.
1 – Who exactly has to file?
All American citizens, as well as green card holders, who earn over $12,000 a year, or just $400 of self-employment income are required to file a US federal tax return reporting their worldwide income.
Even folks living abroad who have never lived in the US or had an American passport but could, due to perhaps having been born in the US while their parents were there temporarily, or due to having an American parent or grandparent, are required to file US taxes. Such people are often referred to as Accidental Americans.
When expats file from overseas, they must convert their income earned abroad into US dollars. They can use any reputable currency conversion source for this, so long as they are consistent in the source they use.
2 – How can expats reduce their US tax bill?
Even though expats always have to file, most don’t end up paying any US taxes.
This is because the IRS has made some provisions available that expats can claim when they file to reduce their US tax bill, most often to zero. The bottom line though is that expats almost never pay more income tax than the higher of either the US income tax rate and the rate in the country where they live.
Many expats hope or assume that a tax treaty exists between the US and the country where they live that protects them from having to pay taxes in both countries.
US tax treaties however contain what’s called a Saving Clause, which states that the US can tax its citizens as if the rest of the treaty didn’t exist, meaning that very few US expats benefit from US tax treaties. Exceptions are often teachers, students and researchers. Expats who can benefit from a tax treaty provision can claim it on Form 8833 when they file.
If you are a U.S. citizen or resident alien, the rules for filing income, estate, and gift tax returns and paying estimated tax are generally the same whether you are in the United States or abroad. – the IRS
The US Foreign Tax Credit allows expats who pay foreign taxes to claim US tax credits to the same value as the foreign income taxes that they’ve already paid in the country where they live.
The Foreign Tax Credit can only be applied to foreign taxes paid on foreign source income though, so not income from American based rents, pension or investment income.
To claim the Foreign Tax Credit, expats must file IRS Form 1116 when they file their annual return. The Foreign Tax Credit is often a good option for expats with foreign source income who pay a higher rate of foreign income tax in their country of residence than the US rate. In this scenario, by claiming the US Foreign Tax Credit expats can often completely eradicate their US tax bill, and they may even have excess US tax credits left over that they can carry forward to use in future years. Expats who don’t owe any US tax because they claimed the Foreign Tax Credit still have to file a US tax return declaring their worldwide income though.
Another IRS provision that expats can claim to reduce and often eradicate their US tax bill is the Foreign Earned Income Exclusion.
The Foreign Earned Income Exclusion allows expats to simply exclude the first around $100,000 (the exact figure rises a little each year due to inflation) of their earned income from US taxation, regardless of whether they’re paying foreign taxes or not.
The Foreign Earned Income Exclusion can only be applied to earned income though, such as salaries, self-employment, wages, commissions – essentially payment for services provided – but not to unearned, passive income, for example from rents, pensions, dividends, or interest.
It doesn’t matter where in the world the earned income is sourced, however the expat claiming the Foreign Earned Income Exclusion must demonstrate that they live abroad in one of two IRS prescribed ways.
The first of these is called the Bona Fide Residence Test. The Bona Fide Residence Test requires expats to prove that they were a permanent resident in another country in the tax year in question, perhaps by having a permanent residency visa, or if their main home is there, or by paying taxes there.
The second way of demonstrating that an expat lives abroad when claiming the Foreign Earned Income Exclusion is called the Physical Presence Test. The Physical Presence Test requires expats to prove that they spent at least 330 days outside the US in a 365 day period that coincides with the tax year.
The Foreign Earned Income Exclusion is often a good provision for expats who earn less than around $100,000, whose income is earned, and who either don’t pay foreign income tax (for example Digital Nomads, who roam from country to country without establishing tax residency anywhere), or who pay foreign income tax at a lower rate than the US rate, so that claiming the Foreign Tax Credit wouldn’t fully eradicate their US tax bill.
Expats can’t apply both the Foreign Tax Credit and the Foreign Earned Income Exclusion to the same income, though in theory they can claim both and apply them to different income, if it is beneficial for them to do so.
Expats who rent their home abroad, who claim the Foreign Earned Income Exclusion, and who earn over around $100,000 can also claim the Foreign Housing Exclusion on Form 2555, so further excluding a proportion of their housing expenses.
In principle, no expat should end up paying more income tax than the higher of the two rates, the US rate and the rate in their country of residence. In practice, most expats don’t end up owing any US taxes (although they still have to file), whether they are paying foreign income taxes or not.
In some cases, where neither the Foreign Tax Credit nor the Foreign Earned Income Exclusion can be applied, perhaps because their only income is passive and US sourced (for example US pension or rental income), expats may have to pay US taxes then claim tax credits in the country where they live to avoid double taxation, if available.
We strongly recommend that expats seek assistance from a US expat tax specialist firm to ascertain what is the most beneficial for them to minimize their taxes given their unique circumstances.
3 – Expats with children
Expats with children who claim the Foreign Tax Credit may also be able to claim the Child Tax Credit.
The Child Tax Credit either gives expats a $2,000 US tax credit per dependent child, or expats who have already eradicated their US tax bill completely by claiming the Foreign Tax Credit can claim a refundable $1,400 tax credit per child, which takes the form of a direct payment.
This refundable credit can be a significant boost for Americans living abroad with children. To claim the Child Tax Credit, the dependent children must be US citizens with US social security numbers. Expats can claim the Child Tax Credit on Form 8812.
4 – Reporting foreign accounts
As well as filing a federal tax return each year, expats may also have to file a Foreign Bank Account Report, or FBAR.
Specifically, expats who have a total of over $10,000 at any time during a year in qualifying foreign financial accounts are required to report them by filing FinCEN form 114 online. FBARs are filed to FinCEN rather than to the IRS, and penalties for not filing (or for incomplete or incorrect filing) are high, so it’s an important aspect of US reporting for expats.
Qualifying financial accounts include checking and savings accounts, investment accounts, and most pension accounts, including any accounts that expats have control or signatory authority over, such as joint accounts and business accounts, even if not in the expats name.
While FBARs are nominally due by April 15th, there’s currently an automatic extension until October 15th.
5 – FATCA and foreign assets
In 2010, the Foreign Account Tax Compliance Act (FATCA) was signed into law, dramatically changing the landscape for US expats.
The new law was intended to help prevent offshore tax avoidance, and it contained two measures towards this end. The first was to require all Americans with significant offshore financial assets to report them every year on Form 8938 (the minimum reporting thresholds vary depending on circumstances, but are typically $200,000 for expats). The second measure was to compel foreign financial firms including banks and investment firms to provide their American account holders balance and contact details directly to the IRS by imposing a tax on those foreign firms that don’t when they trade in US financial markets.
This second measure has been effective, with nearly all (over 320,000 to date) foreign financial institutions of all sorts now complying.
FATCA’s impact on expats has been significant though, as while relatively few of the 9 million Americans who live abroad have to report their foreign financial assets on Form 8938, the IRS can now snoop on expats finances globally.
Furthermore, some foreign banks have simply declined to provide services to Americans due to the additional administrative burden that reporting to the IRS creates.
In summary, expats can no longer remain under the radar with regard to their US tax filing consequence-free.
We strongly recommend that expats who aren’t up to date with their US tax and FBAR filing take steps to become compliant at their earliest convenience.
6 – Amnesty program for expats who need to catch up
It’s not all bad news though, as the IRS has a voluntary amnesty program for expats who are behind with their US tax filing because they weren’t aware that they had to file from abroad.
The program is called the Streamlined Procedure, and it requires expats who need to file back taxes to file their last three tax returns and their last six FBARs, and to self-certify that their previous non-compliance was non-willful.
Expats who backfile under the Streamlined Procedure won’t face any late-compliance fines, and they are also able to retrospectively claim the exemptions or credits described above that minimize or eliminate their US tax bill.
Expats who are behind with their US tax filing should act now though, as the Streamlined program is only available voluntarily, which is to say expats must catch up before the IRS contacts them, perhaps due to information received from a foreign government or bank.
7 – US social security taxes for expats
Expats who work for a US employer, or who are self employed, and even some who work for a foreign employer, may have to pay US social security taxes.
US social security taxes consist of 6.2% for employees plus 2.9% Medicare Tax, or a total of 15.3% of income for self-employed expats (12.4% social security tax and 2.9% Medicare Tax.
Expats may also have to pay social security taxes in the country where they live though. To help prevent double social security taxation, the US has signed Totalization Agreements with 26 other countries. These treaties stipulate that expats who will be living abroad for a short time, typically 3-5 years, should continue paying social security taxes to the US, but not to the country where they live, whereas if they will be living abroad for longer they should pay them in the country where they live but not to the US. Contributions made to either country count towards future social security entitlement in both.
The 15.3% self-employed expats pay can still be a burden though, and some self-employed expats choose to establish a corporation in a low or no tax foreign country which then employs them, so that as an employee of a foreign corporation they aren’t liable to pay US social security taxes. The benefits of this arrangement have been reduced for many expats following changes to the taxation of foreign corporations in the 2017 Trump Tax Reform, and furthermore expats should be aware that not paying social security contributions may affect their ability to receive social security payments when they retire.
8 – Social Security benefits for Americans living abroad
Thousands of Americans retire abroad every year, setting off on a later life adventure in search of a better quality of life.
Americans who retire abroad can have their US social security checks transferred to a foreign bank if they wish, though they should check local tax rules to ensure doing so wouldn’t trigger additional tax liability.
US social security payments, along with other retirement plans other than those from Roth IRA plans, are subject to US taxation, and possibly in the country where they live, too (depending on the rules there), however expats may be able to claim tax credits in their country of residence so as to avoid double taxation.
9 – Expats with a foreign registered business
Expats’ foreign business interests are also subject to US reporting and possibly taxation.
Expats with a foreign registered LLC are required to file Form 8832 initially, and then Form 8858 annually, to elect for it to be considered ‘disregarded’ the way a US registered LLC would automatically be. Once considered disregarded, the LLC’s US reporting flows through its owner’s personal tax return.
All foreign registered corporations that aren’t considered disregarded trigger a reporting requirement on Form 5471 annually by any American who owns at least 10% of the company.
Americans with foreign registered partnerships should report them each year on Form 8865.
Since the recent tax reform, profits of Controlled Foreign Corporations (foreign registered corporations that are more than 50% owned or controlled by Americans overall) are taxed as if their profits are their American owners personal income (due to a provision called GILTI).
Expats with foreign registered businesses should also be aware that any business accounts that they control or have signatory authority over qualify for FBAR reporting.
10 – Expats and state taxes
Some expats may have to continue filing state taxes too while living abroad.
Most states will let expats stop filing state taxes once they demonstrate that they live abroad, however some states want to keep taxing expats who retain any ties to the state, such as property, investments, voter registration, or dependents.
The four toughest states are Virginia, California, New Mexico, and South Carolina.
Expats should ensure though that they check the rules in the state where they last lived to ensure that they don’t get any surprise state tax bills down the road.
11 – Expats with foreign real estate
The US tax system treats foreign residential property owned in an expat’s name the same as if it were US property.
This means that mortgage interest and property taxes are deductible, and in general the property ownership isn’t reportable until it is sold, at which point any capital gain made is subject to US capital gains tax rules, the same as if it were in the US. (If the owner meets certain residential requirements in the property, they are also eligible for an exclusion of up to $250,000 USD of the gain ($500,000 USD if married filing jointly).
Expats with foreign rental properties meanwhile should report the income on form 1040. Rental income is considered passive income rather than earned income, so it can’t be excluded using the Foreign Earned Income Exclusion. Expats who claim the Foreign Tax Credit though to offset the US tax due on this income against foreign income taxes that they’ve paid in the country where their rental property is.
There may be local advantages for expats in owning foreign real estate in a corporation, partnership or trust, however Americans who own property through foreign entities are subject to additional US filing requirements, as described above.
12 – Seek assistance
US tax filing for expats is typically more complex than filing from the US. Since FATCA came into effect, the IRS is now able to enforce US tax filing globally, and in cases when they consider that an American owes over $50,000 of US tax (without taking into account exclusions or credits, if they haven’t been claimed) revoking US passports. This means that expats should ensure that they are compliant.
Expats with very simple and straightforward circumstances might consider filing their own US tax return, however most expats and certainly any with any doubts or questions with regards to filing – and filing in the most beneficial way possible, given their circumstances – should seek assistance from a US expat tax specialist to ensure they file in a way that minimizes their US tax bill in both the short and long term.