Generally speaking, U.S. citizens and green card holders are taxed on worldwide income and subject to certain foreign assets reporting requirements as well. For your financial assets held outside the United States, there is not a lot of things you could do to reduce the burden of reporting besides transferring it over. However, for your foreign income, the following steps may help you save some taxes associated with it.
1. Check whether you are qualified for Foreign Earned Income Exclusion (FEIE).
For 2017 tax year, you can exclude up to $102,000 as an individual in your foreign earned income for your federal income tax. Sounds great? Let’s see if you are eligible first. This is directly from IRS website:
“To claim the foreign earned income exclusion, you must have foreign earned income, your tax home must be in a foreign country, and you must be one of the following:
- A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year,
- A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, or
- A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.”
Firstly, FEIE only applies to foreign earned income. Earned income mainly includes wages, salaries and net earnings from self-employment. Interest, dividends, capital gains, pension and social security from the government are not earned income.
Secondly, according to IRS, “your tax home is the general area of your main place of business, employment, or post of duty, regardless of where you maintain your family home”. You could find the detailed definition and explanations here. In general, if you were assigned to another country or worked in another country for more than a year, you may claim that country as your tax home.
Last but not the least, you have to meet either the Bona Fide Residence Test, which is defined in the first two bullet points above, or the Physical Presence Test which is the third bullet point. The Physical Presence Test is relatively straightforward. It is a common misunderstanding that one needs to stay in foreign countries for more than 330 days in the previous tax year. In fact, it only requires a consecutive 12-month period. For example, if you stayed in China from June 1, 2016, to July 1, 2017, you are eligible for the pro-rated exclusion amount for the year 2016 and 2017 based on the number of qualifying days in each year if you also meet all other requirements. Regarding the Bona Fide Residence Test, it is more flexible on the actual days you stay abroad, but it is more stringent on your intention or the purpose of your trip and the nature and length of your stay. For instance, vacation days in other countries are counted in the 330 days under Physical Presence Test. Under Bona Fide Residence Test, you will fail the test if you take a vacation to China for a year. Another thing worth mentioning here is that “an uninterrupted period” doesn’t mean you cannot leave the country at all. You could still take temporary trips to other countries or even back to the U.S. for vacation or business as long as you show a clear intention of returning to the foreign country.
Form 2555 should be used to claim the FEIE. Under certain circumstances, you could use Form 2555-EZ instead.
2. If you are eligible for the foreign earned income exclusion, you can also claim the foreign housing exclusion or deduction from your gross foreign earned income.
The difference between the exclusion and the deduction is that the exclusion only applies to the housing expenses provided by your employer and the deduction can only apply to the amount paid from self-employment income. Both the exclusion and deduction are subject to certain limitations, and the actual amount will be calculated on Form 2555.
3. Make a comparison to see which one can save you more taxes: the foreign earned income exclusion or the foreign tax credit.
You could take either Foreign Tax Credit or Foreign Earned Income Exclusion (FEIE) but not both. In most cases, a foreign tax credit, which helps to reduce your federal tax liability by the amount of foreign income taxes you paid dollar for dollar, is better than a foreign tax deduction, which only reduces your income rather than your taxes.
In general, if you have paid or accrued income tax imposed on you by a foreign country, you can claim the credit on Form 1116 for individuals or Form 1118 for corporations. To make it clearer, only foreign taxes paid on income such as wages, interest, dividends, and royalties qualify for foreign tax credit.
Then, which one is better? First of all, you cannot take the foreign tax credit or deduction on the income you exclude under the foreign earned income exclusion or the foreign housing exclusion. However, you could still claim the credit on non-earned income like interests and dividends which are not covered under FEIE or any additional earned income on top of the FEIE limit. For example, an individual who has foreign earned income over $102,000 in 2017 may use FEIE to exclude the first $102,000 and then take the credit for the rest. Secondly, for FEIE, to use it or lose it. In contrast, the unused foreign tax credit can be carried back for one year or carried forward for 10 years. Lastly, when calculating your federal income tax, you need to figure out your income tax on your total income including the FEIE amount first. Then you can subtract the part of the tax on the FEIE amount. In other words, your marginal tax rate can easily start with 15% or even 25% based on your filing status and other deductions and exemptions.
In summary, from a pure tax perspective, assuming you are eligible for both FEIE and the foreign tax credit, you are generally better off using the credit if your foreign tax rate is higher than your U.S. tax rate.
Hopefully, you may get some tips from my post. U.S. tax laws are complicated and constantly changing. Some general rules and guidance may not apply to your specific situation. It is strongly suggested that you talk to a tax professional like us who specialize in cross-border tax issues and can help you make a right decision.