Americans living abroad are required to continue filing US taxes just as if they were still living in the States, reporting their worldwide income.
In fact, filing US taxes is often more complex for American expats than for Americans living in the States, as they often have extra reporting requirements under FATCA or FBAR, while to avoid having to pay US taxes they must file extra forms to claim one or more of the exemptions that the IRS has made available for this purpose.
The two most effective and commonly claimed IRS exemptions for expats are the Foreign Earned Income Exclusion and the Foreign Tax Credit, however many expats are unsure as to which is the best for them to claim. In this article we look at what circumstances might indicate that claiming one may be preferable over the other.
When US expats should choose to claim the Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion allows expats to exclude the first around $100,000 (the exact figure rises a little each year) of their earned income from US tax.
To claim the Foreign Earned Income Exclusion, expats must first prove that they live abroad in one of two ways, either using the Bona Fide Residence Test, which requires them to prove that they are a resident in a foreign country, or the Physical Presence Test, which requires them to prove that they spent at least 330 days outside the US in a tax year (or in a 365 day period that coincides with the tax year).
Expats should claim the Foreign Earned Income Exclusion if all of the following apply:
– they earn less than around $100,000
– their income is entirely actively earned (rather than having passive income such as rents , pensions or dividends)
they don’t pay taxes in any foreign country, or they pay taxes in a foreign country at a lower income tax rate than the US rate
“Once you choose to exclude either foreign earned income or foreign housing costs, you cannot take a foreign tax credit for taxes on income you exclude.” – the IRS
Expats with these circumstances should claim the Foreign Earned Income Exclusion by filing form 2555 when they file their federal return.
When US expats should choose to claim the Foreign Tax Credit
The Foreign Tax Credit allows expats to claim a $1 US tax credit for every dollar equivalent of foreign tax that they’ve already paid abroad.
Expats should choose to claim the Foreign Tax Credit if:
– they pay income tax abroad at a higher rate than the US rate, and/or:
– they earn over around $100,000, and/or
– their income is passive, or a mix of active and passive, and/or
– they have American dependent children under the age of 17 years old and would like to claim the Additional Child Tax Credit $1000 refund per child
To claim the Foreign Tax Credit, expats should file form 1116 when they file their federal tax return.
Can US Expats claim both the Foreign Earned Income Exclusion and the Foreign Tax Credit simultaneously?
Expats can claim both exemptions, but they can’t apply them to the same income.
The most common circumstance when an expat might claim both exemptions is if they earn over $100,000 and pay foreign income tax at a lower rate than the US rate. In this scenario, they will pay less US tax by claiming the Foreign Earned Income Exclusion to exclude the first around $100,000 of their income, then the Foreign Tax Credit for their income over the Foreign Earned Income Exclusion limit, than if they solely claimed the Foreign Tax Credit.
Expats who are behind with their US tax filing can claim both Foreign Earned Income Exclusion and the Foreign Tax Credit retrospectively as long as the IRS hasn’t contacted them yet. Once the IRS contacts them, they normally won’t be able to back claim these exemptions, meaning they’ll face a US back taxes bill even if they’ve already paid foreign taxes.
Expats can catch up without facing penalties however using an IRS amnesty program called the Streamlined Procedure, assuming that they do so before the IRS contacts them.