3 Key US Tax Considerations for American Expats

American Expat taxUpdated April 2016

The tax season is well under way. As an American living abroad, you may say “I don’t have to worry yet about filing my US taxes, I’ll get an automatic extension because I live abroad.” Not so fast.

It is correct that you have more time to file your tax return, but that doesn’t mean you have more time to pay. So you need to start thinking about and preparing for your tax return.

Let’s look at 3 important things you should know about filing US taxes as an American expat.

This one is for US Americans only – Sorry to other folks

When I say “Americans” here, I refer not only to US citizens. US Green Card holders for example are considered US residents for tax purposes and have to file US tax returns, even when living abroad. Check out the IRS publication 54 for more info. Nomadfinance101 also explains tax issues in plain English for US individuals abroad.

Apologies to my non-US expat readers. I can only speak to the situation for Americans because the US is where I file tax returns. Whatever country you are from, please make sure to check out your home country requirements.

I also need to point out that I am not a tax professional or financial planner or anything like that. The info I provide here is informational only and should not be relied on. Please check with your tax adviser. He/she will definitely be much more qualified than I am on this matter. I’m only trying to get you started to think about it and help you prepare for your discussion with your tax adviser. Enough disclaimer, let’s get started.

1. When to file and when to pay

When you are living abroad you get an automatic 2-month extension to file your tax return. So you don’t have to file and pay any taxes due until June 15. And you don’t have to do anything to get that extension, other than living and having your main place of business outside the US on the April tax due date, and attaching a statement to your return. For  2016, the tax date falls on April 18, not the 15!

If you owe tax however, you may still have to pay interest on that tax, calculated from the April tax due date. Please check out the IRS website on this topic.

2. Foreign Earned Income Exclusion (FEIE) or Foreign Tax Credit (FTC)

There are two good options for reporting the income you earned abroad and determining how much tax you owe on it. These options are designed to make sure that you don’t have to pay twice, once in the US and once in your current country, which is China for us right now. While the first option, Foreign Earned Income Exclusion, is most popular, the second one, Foreign Tax Credit, deserves a good look, too. It may save you a few bucks – or a lot.

Excluding (part of) the income you earned abroad

The Foreign Earned Income Exclusion FEIE allows you to exclude a certain amount of income earned in a foreign country from federal taxes, so you don’t have to pay US income taxes on that foreign earned income. To be able to claim this exclusion you have to meet a few requirements:

  • you have to have earned income, so a salary or wages or fees you received for providing your services, that generate in a foreign country (in our case in China),
  • your tax home must be in a foreign country, meaning you live and work there,
  • and you qualify as a resident in a foreign country (more about that below).

Check out the IRS website for more details on the requirements and on the amount you can exclude (here is the link to IRS FAQ’s about international tax matters for individual tax payers.)

You have to pay income tax on any amount of foreign income you earned above the FEIE limit, and the same tax brackets apply as if you hadn’t excluded any income. If your income is below the limit of allowed FEIE, you don’t owe income tax on that (you still may owe taxes on other income, like investment income or domestic US earned income). But you still need to file a tax return!

And only because you can exclude income from your federal tax return does not mean that your US home state treats it the same way. Not all states allow for an FEIE, California for example does not have an FEIE.

One thing to be aware of is that if you exclude all your foreign earned income, you won’t be able to make any IRA or Roth IRA contribution. Those contributions require you that actually have (non-excluded) earned income. There may be other tax situations, for example tax credits, where having non-excluded earned income is also an advantage. Check with your tax adviser.

Taking a credit for income tax you paid abroad

The Foreign Tax Credit FTC allows you to take a credit for the tax you paid abroad. So if you paid Chinese income tax on the income you made in China, you can use that Chinese tax amount to offset your US tax burden.

You can only apply the FTC on non-excluded earned income, so you can’t use the FEIE and then apply a tax credit against income you just excluded. No double dipping!

What if your foreign income is higher than your maximum allowed FEIE amount? Well, first, congratulations on your good earnings. Second, you can apply the FTC for the foreign tax you paid on the non-excluded income. The IRS tax forms and publications help with the math for determining the correct amounts.

Important for couples is that you can only apply the FEIE amount per person and for that person’s income. A married couple can not combine their FEIE amounts and apply it against the higher or the combined income.

How do you know how much tax you paid on your income in China so that you can claim that for the FTC? After the end of the year, an official tax document is generated and should be provided to you by your employer. This document is also needed to transfer money out of China to prove that you paid your Chinese taxes on it.

FEIE or FTC – Which one to use?

You can choose if you want to use the FEIE (if you qualify, see above) or the FTC. But which one should you use?

Many people, including some tax advisers who may have less experience in international income tax matters, think the FEIE is better because it seems so straightforward. Just exclude the income and no taxes due. Done. But if the FEIE really makes more sense for you than the FTC depends on your specific tax situation.

To find out which one is more beneficial for you, the FEIE or the FTC, you need to run both scenarios. You can have your tax adviser do that (that’s why it is important to choose one with experience in expat taxes). Or you can do it yourself.

I use TurboTax for preparing and filing my tax returns. (You can easily buy it from Amazon.com and download it to your computer.) You have to be really familiar with US expat taxes and willing to leave the guided process and dive directly into the forms to do your expat taxes yourself.

Using a tax software also makes it easy to e-file, so you don’t have to deal with the hassle of mailing from China. At least for the federal tax returns. Individual states differ if they allow e-file for foreign address holders or not.

3. Bona Fide Residence or Physical Presence Test

These two test can be applied to determine if qualify for the Foreign Earned Income Exclusion. The Bona Fide Residence Test is much more subjective than the Physical Presence Test. If you get audited it may be much harder to prove to the IRS that you really qualify under the Bona Fide Residence Test as you claim. Therefore, the Physical Presence Test is the better way to go, if at all possible.

Bona Fide Residence Test

For the Bona Fide Residence Test, you need to be able to prove that you fully shifted your residence to your new tax home. Any ties that you maintain to your old US residence like regular family visits, any memberships, maintaining property, etc, may be used against your claim.

The burden is on you to prove where your residence is if the IRS questions it. Even the IRS strongly advises to use the Physical Presence Test instead to avoid any ambiguity.

Physical Presence Test

For the Physical Presence Test  you need to keep good track of all days spent stateside. The IRS accepts your passports with the stamps as evidence of your comings and goings, so don’t get rid of an old passport for at least 3 years to document your travel.

You must meet a minimum threshold of 330 full (!) days spent within a 12 month period in foreign countries. The 330 days don’t have to be consecutive, but they have to be full days. All foreign countries, not just the tax home country count towards that number. And you can select any 12 month period that starts or ends somewhere within the tax year.

You should select a 12 month period where you spent the greatest number of days in foreign countries. This is important because it also affects the amount of foreign earned income you can exclude. (The maximum FEIE is prorated, calculated based on that number of days.)

Other important reporting requirements – Don’t skip this!

These 3 considerations above are important for Americans living and working abroad. But of course, there is more.

There are specific reporting requirements for foreign bank accounts (FBAR) and foreign financial assets (FATCA) that don’t have direct tax implications but that you absolutely need to be aware of. Failure to comply with those reporting requirements can lead to significant fines, so I strongly suggest you learn more about those. The IRS website is a good starting point.

If you use TurboTax to prepare your tax return, it will walk you through those reporting requirements and prepare the necessary forms you have to file. But be aware that expat taxes are more complex than the simple TurboTax guided process covers – you sometimes need to read up on specific topics beyond the help function and go into the tax forms directly.

No matter if you DIY or have someone do it for you – Just get it done!

Thanks for bearing with me through this tremendously exciting topic. I know paying US taxes as expat is one of the experiences you were really looking forward to when moving abroad…

For more tax info and resources

The IRS has used to have local offices in major cities around the world. The Beijing IRS office conducted great yearly tax workshops, not only in Beijing but also in other Chinese cities. But the IRS closed the Beijing office in late 2014 and even the toll-free international hotline in November 2015. You can still find some tax info at the embassy’s US Citizen Services website. For explanation of the FEIE and other tax concepts in detail, without using much tax jargon or legalese, check out Nomad Finance 101.

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