Foreign Income Taxes Explained
People often joke about creating offshore accounts to hide money from the taxman, but the IRS isn’t laughing. In reality, Uncle Sam has an incredibly long reach and no qualms at all about collecting foreign income taxes from money Americans earn abroad. Here’s what you need to know if you’re earning income both in the U.S. and abroad.
The US Taxes Global Earned Income
Although it’s one of only two countries that does so, the United states taxes global income. Even if you’re living and working in another country, you’re still quite likely incurring an American tax liability. Of course, you may also owe tax to the nation in which you’re living and working. Having to potentially pay tax in two nations makes foreign taxation issues quite complex.
What is the US Foreign Tax Credit?
To avoid double taxation, the IRS instituted the foreign tax credit (FTC). Under this tax provision, you can get credit for any foreign taxes that you’ve paid on a dollar for dollar basis.
Let’s say, for example, that you’re a United States citizen but you lived and worked in the United Kingdom all year. Each week UK taxes were withheld from your paycheck and paid to the UK government. In all, your UK tax liability for the year was $5,000 and you paid it in full. Now you must prepare a US tax return.
When you do, you find that you owe the IRS $6,000 worth of tax on the income you earned in the UK. The FTC allows you to claim credit for the $5,000 you already paid to the UK. As a result, you’ll only need to pay $1,000 to the US government.
Foreign Taxes that Qualify for the FTC
Of course, the tax code is never quite that simple, and not all foreign tax liabilities get treated the same. To qualify for the FTC, any taxes you pay to a foreign government must be a true income tax. It cannot be a property tax or other type of tax payment. Taxes for which you can take the credit must also be for earned income only. You can’t take credit for taxes a foreign government charges on your investment or interest income, for example.
It’s also required that you claim only taxes that you’ve already paid to a foreign government. You can’t take the FTC for money you may pay in the future. You can only take it on taxes you’ve already paid or accrued (owe). If you paid $5,000 in tax money to a foreign government but then received a $1,000 tax refund, you can only claim the $4,000 you actually paid for the FTC. Tax refunds and deductions cannot be claimed as taxes paid.
How to Claim the Foreign Tax Credit
In order to claim the US FTC, you must first file your taxes in the applicable foreign country. Depending on the country and the tax year they use, you may not have time to do this before the US tax deadline of April 15. As such, the IRS automatically extends the tax filing deadline for Americans living abroad to June 15. If you need even more time, you can file an extension until October 15.
When it’s time to prepare your American tax return, you’ll need to file IRS Form 1116. This two-page form will require you to state the relevant facts and figures about your foreign income and taxes. To complete it, you’ll need to know the value of the foreign tax you paid in both American currency and in the foreign currency. The form will also ask what type of income you earned and whether or not you received any tax deductions on your foreign tax. The form itself will walk you through the information you must provide — all you need to do is keep good records.
What is the Foreign Earned Income Exclusion (FEIE)?
Claimed on IRS Form 2555, this exclusion can save taxpayers quite a bit of money. As always, however, there are very specific rules about who qualifies. Note that this exclusion has two parts: the earned income exclusion and the foreign housing exclusion. We’ll explain both.
The Foreign Earned Income Exclusion
Perhaps even better than the FTC is the FEIE. Under this part of the tax law, Americans living and working abroad may be able to exclude some or all of their foreign income from US taxation. The amount changes every year, but in 2020 qualified taxpayers could exclude up to $107,600 of foreign income.
The Foreign Housing Exclusion
In some instances, a foreign employer may pay all or part of your housing cost while you live abroad. For example, let’s say a German company wants you to come and work on a project for them. To convince you to take the job, they agree to pay your housing costs while you work for them. In this case, your housing expenses technically become part of your compensation package, but the IRS will cut you a break and allow you to exclude part of this amount from your taxable income.
Calculated on Form 2555, the housing exclusion is determined by calculating 16 percent of your eligible foreign income exclusion. Divide that 16 percent by the number of days in the year – 365 in a normal year and 366 in a leap year. This is your exclusion per day. Multiply this exclusion by the number of days you lived in the qualified residence. If this sounds confusing, don’t worry – the line instructions on Form 2555 will walk you through it.
This is where we must mention that there is a foreign housing deduction in addition to the exclusion. Self-employed people working abroad can’t take the housing exclusion, but they can take the foreign housing deduction. Although similar, the exclusion and the deduction are not exactly the same thing. Both are calculated on Form 2555, however.
Rules to Qualify for the FEIE
In order to qualify for the Foreign Earned Income Exclusion (FEIE), you must meet one of three conditions. One is that you are an American citizen who lived in a foreign nation all year, essentially establishing residency there. You may also qualify for the FEIE if you’re a US resident alien and a citizen of another country with whom the IRS has an income tax treaty. (As of 2021, the IRS has such treaties with more than 70 countries.)
The third qualification for the FEIE is if you are a US citizen or resident alien who was aboard for at least 330 days for 12 consecutive months. This provision requires only that you lived abroad, not that you established a residence abroad. If you spend a year traveling and working your way across Europe, for example, you can still meet this qualification.
Just as you must meet certain qualifications for the FEIE, so must your income itself. This exclusion applies only to earned income. That means wages, salaries and self-employment income. You can also count bonuses and commissions as earned income. Income from foreign investments, interest and other passive activities doesn’t count, however, and cannot be excluded from your US taxable income.
Interactive Tax Assistant (ITA) Tool
Is your head spinning yet? All of these rules and exceptions can even make us a little weak in the knees. Fortunately, the IRS has a tool you can use to help put it all together when it comes to foreign tax and income.
Located here, the ITA tool allows you to search for a specific term or click on a listed tax question, such as “Can I Exclude Income Earned in a Foreign Country?” Once you click your question, the website will take you through a series of questions to help you determine the right answer for your unique situation.
The purpose of the ITA is to help taxpayers, not track down wayward Americans who may be a bit behind on their tax bill. The tool does not require or track any personal information and allows you to find tax answers anonymously. That way you can get help filing your taxes accurately now, even if you’ve hit a snag in the past.
Foreign Tax Credit (FTC) Vs. Foreign Earned Income Exemption (FEIE)
The FTC and FEIE are both helpful tools for those with foreign income, but they’re also complicated snippets of tax law. Now that you know a bit about both, let’s solidify your understanding of them by comparing and contrasting them. There are two things that both have in common. Both apply only to foreign earned income and both strive to avoid double taxation. Each does so in a very different way, however.
The FEIE lets you pretend that some of your foreign income never happened. You deduct this “free” income from your taxable income before calculating how much tax you owe Uncle Sam. That income may or may not be taxed by a foreign government, but the IRS turns a blind eye, so to speak, and lets you have this money tax free.
Under the FTC, you essentially figure out your taxable income as you normally would and then take credit for foreign tax you already paid. In this scenario, if you owe Uncle Sam $10,000 in taxes on your foreign income but you already paid $6,000 to a foreign government, you pay only the $4,000 that remains. You’re essentially telling the IRS, “I already paid $6,000 worth of tax on this money to Country A. If you want it, you’ll have to discuss it with them.”
Still Confused? Here’s what to do!
Still have questions? We hear you. Foreign tax credits get complicated quickly. To make matters even more difficult, you’ll have to choose between the FTC and the FEIE — you can’t take both on the same money. As always, the professionals at Picnic Tax stand ready to assist you. Your foreign tax questions aren’t foreign at all to us.
Our friendly and knowledgeable CPAs can help you decide how to navigate your unique foreign income tax situation. We’re here to help you figure out how best to reduce your tax liability today and navigate the foreign income rules tomorrow, letting you move forward with confidence knowing you have a solid tax strategy in place for the future.