Many foreigners are surprised to learn that they have to declare income earned in the United States. Fortunately, the IRS does offer some mechanisms to help prevent double taxation, such as the Foreign Earned Income Exclusion and the Foreign Tax Credit.
Some U.S. states allow foreign visitors to get a sales tax refund at participating stores. However, getting this refund is not easy.
Taxes on Foreign Income
The U.S. can tax many different types of income, including wages, interest, dividends, and rental income. Wages are taxable in the US, even for overseas self-employed contractors. Interest and dividends from banks and stocks are also taxable. Rental income is usually taxed when you own or rent out property in the US. If your income comes from a foreign country, you can benefit from a treaty if you qualify for one. Generally, treaties aim to prevent double taxation, which means you only pay taxes once. You can determine which countries have treaties with the United States by consulting IRS Publication 515, Withholding Tax on Nonresident Aliens & Foreign Entities.
Expats often avoid double taxation using the Foreign Earned Income Exclusion (FEIE). This exclusion lets you exclude a portion of your foreign earned income from your US tax return, up to $153,600 in 2023. To qualify, you must meet criteria like spending a set number of days abroad annually and passing the bona fide residence or physical presence tests.
In addition to the FEIE, other tools are available for U.S. expats, such as the Foreign Taxation Credit. These are helpful for individuals relocating to countries with higher income taxes than the U.S. or those earning above the annual FEIE limit.
American citizens and permanent residents must report their global income annually on their tax returns. This encompasses income earned in the United States and worldwide, where they live, work, or hold assets. However, several exceptions and special rules can lower a person’s tax liability. If you have questions about your taxes, you should consult a professional.
A tax treaty is a bilateral agreement between two countries aimed at preventing double taxation of specific income types. While treaty terms vary, they generally prevent the U.S. and your home country from taxing the same income differently or simultaneously. They may also exempt certain income, offer retirement savings benefits, and involve sharing information about residents’ tax compliance between the two countries. Tax treaties usually apply at the federal level, although some individual state taxation rules may also consider treaty provisions.
Typically, you must file Form 8833 to claim benefits under a tax treaty. The IRS’s website has a tool that allows you to search for the status of your country’s tax treaty if it has one. You can also download and use a treaty matrix that displays the status of all your country’s treaties for easy reference.
For example, consider a professor from the Philippines who is temporarily in the United States to teach at a university. Many tax treaties include provisions that exempt income of this type from taxation in the United States provided the individual has a short-term residence abroad, such as two years or less. However, the professor must still report this income on her U.S. tax return and pay the appropriate taxes.
Tax treaties let the US credit citizens and residents for foreign income taxes, lowering owed taxes. Excess credits can be carried forward. Tax treaty rules are complex. Consult an accountant for your situation. Treaties don’t override US income rules.
Taxes on Investment Income
The US taxes its citizens worldwide, even when living abroad. Most countries use territorial taxation, taxing income earned within their borders. For American expats earning investment income from foreign investments, the IRS requires them to file a U.S. return and pay U.S. tax on these earnings. However, the U.S. has a provision that helps reduce or eliminate double taxation on this type of income.
The law known as the Foreign Tax Credit provides a dollar-for-dollar tax credit for any “qualified” foreign taxes that the individual paid or owed. This includes taxes on capital gains, interest, dividends, and other types of income. The rules relating to which foreign taxes qualify for the credit are complex and specific to each foreign country.
U.S. expats should seek advice from qualified professionals due to complex investment income tax laws. Accountants and lawyers can help with tax returns, liability calculations, risk reduction, and compliance with the Foreign Account Tax Compliance Act (FATCA), which mandates foreign financial institutions report specific account information to the IRS for U.S. persons.
In addition to the federal tax code, many individual states have their own state-level rules that affect investment income for foreigners living in the United States. For example, some states have higher capital gains rates than others. In addition, a number of states allow individuals to claim a personal exemption against capital gains taxes.
For passive foreign income like interest or real estate rents, the IRS handles it like domestic income, as reported on Form 1040 Schedule B. Additionally, taxpayers must file a Foreign Bank Account Reporting form with foreign banks if balances exceed specified thresholds.
The United States has income tax treaties with a number of countries, and these agreements help prevent double taxation. However, these treaties only apply to certain items of income and may not fully protect foreigners from U.S. taxes. Expats need to file a federal return declaring their worldwide income, and they may have to pay U.S. taxes even though they live abroad.
One way to reduce the chance of double taxation is to take advantage of exemptions like the Foreign Earned Income Exclusion and the Foreign Tax Credit, both of which offer dollar-for-dollar credits for taxes expats have paid in other countries. However, expats must file to claim these credits, and they should strategize which ones they use depending on their individual circumstances.
For example, expats who earn around $100,000 per year or less can exclude this amount from U.S. taxes by filing Form 2555 with their federal returns. However, they need to meet several requirements, such as spending a certain number of days outside the country, proving their ties to the country, and filing a U.S. tax return.
Similarly, expats who didn’t realize they had to file a federal return while living abroad can catch up without facing penalties using the Streamlined Procedure. The streamlined procedure allows expats to backdate their tax filings and take advantage of the exemptions (and tax treaty provisions, if applicable) that let them avoid paying double taxation on their overseas income.