To some people’s surprise, U.S. citizens and permanent residents living abroad have to file U.S. tax returns and pay U.S. taxes on income they earned in the country where they are. You have a tax obligation to the United States as long as you’re a citizen or permanent resident—regardless if you’re currently living in Mexico City, Amsterdam, or New York City.
Your expat tax filing requirement doesn’t change even if you’re paid by a foreign employer overseas. In addition to federal income taxes, some U.S. citizens living abroad also need to file state taxes as well, depending on their last state of residence.
What Are Foreign Earnings?
During the time your tax home is in a foreign country, foreign earned income is defined as:
- Professional fees
- Other amounts received as compensation for personal services. Where you performed the services defines your income as foreign, not where or how you are paid.
- For instance, income received for personal services performed in Italy is foreign earned income, even if the employer is American and your pay is deposited in an American bank.
Most American expats do not end up owing U.S. taxes
The United States taxes citizens and permanent residents on all of their worldwide income. However, if you are a U.S. resident alien or citizen who lives and works overseas, you may be able to earn exclusions and credits on all or part of your foreign earned income. Because of these exclusions and credits, U.S. expats usually wind up owing nothing to the U.S. tax authorities.
While you are living abroad, you will pay income taxes to the country where you are living. In addition, you have to report your foreign earned income to the IRS. This makes it appear that you will be double-taxed. However, there are a variety of provisions in place to prevent Americans from being double-taxed on foreign earned income.
In most situations, U.S. expats can offset foreign earned income with:
- Tax treaties – To prevent double-taxation, U.S. taxes for expats are offset by income tax treaties with more than 70 countries.
- Foreign Tax Credits – Foreign tax credits are used to claim a dollar-for-dollar credit on foreign taxes paid on income from your expat job. If you live abroad and you have to pay taxes or have acquired a foreign tax liability, you may qualify.
- The Foreign Earned Income Exclusion – This is the most common and broadest aid to prevent double taxation. You qualify if you live and work overseas and pass either the Bona Fide Residence test or the Physical Presence Test.
Do I Qualify for the Foreign Earned Income Exclusion?
Both U.S. citizens and resident aliens may be eligible for foreign earned income exclusion:
- United States Citizens – U.S. citizens with a tax home in a foreign country may be able to exclude a certain amount of income (the amount changes for every tax year) if they meet either one of two tests:
- The bona fide residence test – In order to meet the bona fide residence test, you must have established your residence in a foreign country. Your bona fide residence is not necessarily the same as your domicile.
- The physical presence test – You meet the physical presence test if you are physically present in a foreign country for 330 full days during a period of 12 consecutive months. The 330 qualifying days do not have to be consecutive.
- Resident Aliens – Resident aliens of the United States with a tax home in a foreign country may be eligible for the exclusion if they meet one of the following qualifications:
- The physical presence test, or
- If they are citizens or nationals of a country with which the United States has an income tax treaty with an applicable nondiscrimination clause, and they meet the bona fide residence test
If you want to pass the Bona Fide Residence or Physical Presence Test you need to track your time carefully. Tracking your time is essential because you could fail the Physical Presence Test if you’re off by even a few hours. To qualify, you must have been in a foreign country for 330 full days out of the year—the “full days” is where people make mistakes. If, for example, you’re on a 12-hour trans-Atlantic flight, those 12 hours will not count toward your full 330 days because you’re in international airspace, not your foreign home country.
To qualify as a Bona Fide Resident, for the first year you need to have been living in a foreign country for an entire tax year, which is where many expats get confused. If you go back to the U.S. to visit family for a month, the time you spend in the U.S. does not count.
Foreign Housing Deduction
People who qualify for the foreign earned income exclusion are also likely to qualify for the foreign housing deduction, which can further reduce their tax liability. The foreign housing deduction is an allowance for taxpayers who live and work in a foreign country. They may exclude from income any amount that their employer gives to them to cover costs related to housing. The exclusion applies regardless of whether the expenses are paid directly to the taxpayer or paid on their behalf.
To qualify for the foreign housing exclusion and deduction, taxpayers must meet the same time requirements as those required for either the bona fide resident or physical presence tests.
What Happens if You Don’t Pay Your Taxes?
Expat tax penalties for non-compliance range from monetary fines to losing your passport. Yes, you can lose your passport if you’re not compliant with your U.S. expat taxes. You can also face fines and penalties ranging from a few thousand dollars to jail time for serious tax evaders.
What if You Did Not Know You Had to Report Foreign Income?
If you’re a U.S. citizen or permanent resident living abroad, and you have never filed a tax return before, you will not be penalized for failing to report foreign income. The IRS built in a safeguard for honest expats who truly didn’t know they had to file. To qualify, you must:
- Have lived in a foreign country for at least 330 days during one of the last three years
- Confirm it was a genuine mistake you failed to file your U.S. tax return and pay your taxes
What Can I Do If I Need Help with Taxes on My Foreign Income?
International tax is an extremely complex area of the law. You may want to consult a tax lawyer familiar with U.S. tax laws or one who specializes in international tax. Tax problems can arise for a variety of reasons:
- Late filing of taxes and failure to pay fines associated with late filing is among the most common ways to get into trouble with the IRS. A tax lawyer can identify exceptions to these cases where tax penalties should not be imposed and can argue in court or negotiate a deal with the IRS to eliminate them.
- Failure to keep copies of tax returns is another common tax issue. Tax returns from the previous year serve as evidence that taxes were indeed filed and can be referred to if a tax return needs to be amended. Your attorney will keep copies of your returns and your records in case they are ever needed.
An experienced tax attorney will be able to answer your questions and concerns regarding your foreign income.