For US citizens living abroad, the reality of owing taxes to the United States can be surprising and, at times, confusing. Most countries tax their residents on income earned within their borders or impose tax obligations based on residency rather than citizenship. However, the US follows a unique system: it taxes its citizens and residents on their worldwide income, no matter where they live. Let’s explore the reasons behind these tax obligations, explain what income is taxable, and outline how to reduce your US tax liability while residing abroad.
If you need assistance with filing your US taxes, don’t hesitate to reach out to Universal Tax Professionals. We specialize in providing comprehensive US expat tax services tailored to meet the unique needs of Americans living abroad.
Citizenship-Based Taxation
The primary reason US citizens living abroad owe taxes is rooted in what is known as citizenship-based taxation (CBT). Unlike many other countries, which apply residence-based taxation, the US requires all its citizens—whether they live in the US or abroad—to file taxes on their global income.
Key reasons for citizenship-based taxation include:
Historical Precedent: The US introduced citizenship-based taxation in the 1860s. This policy was originally enacted to deter citizens from fleeing the country to avoid Civil War-era taxes. Though its origins were specific to a historical period, the approach has remained unchanged.
Taxpayer Loyalty: The US government views taxes as a civic duty, expecting citizens to contribute regardless of where they reside. This approach also entitles American citizens living abroad to certain protections and rights.
Funding Government Services: By taxing its citizens abroad, the US seeks additional resources to fund essential services and safeguard citizens globally, including embassy services, military protection, and other government-supported benefits.
What types of income are taxable for US Expats?
As a US citizen living abroad, you are required to report all income, regardless of where it’s earned. Here’s a breakdown of the various types of income subject to US taxation:
- Wages and Salaries: If you work abroad as an employee, your salary is subject to US income tax, even if your foreign employer doesn’t withhold US taxes.
- Self-employment Income: Freelancers, consultants, and business owners earning income abroad are also subject to US self-employment taxes.
- Investment Income: Income from investments such as dividends, capital gains, and interest is also taxable. Even if your investment accounts are based outside the US, you must report this income to the IRS.
- Rental and Property Income: Income from foreign rental properties or real estate investments abroad is also subject to US tax.
- Social Security and Pension Payments: If you receive social security benefits or pension payments, these are generally taxable by the US government. However, there may be treaties that exempt or reduce this tax.
Each income type is subject to tax reporting, which can complicate your tax situation. It’s essential to be aware of what counts as taxable income to avoid penalties and ensure compliance.
Foreign Earned Income Exclusion (FEIE)
One way to reduce your US tax liability while living abroad is through the Foreign Earned Income Exclusion (FEIE). This tax provision allows you to exclude a certain amount of foreign-earned income from US taxation each year, provided you meet specific requirements. In 2024, the exclusion limit is $120,000.
To qualify for the FEIE, you need to meet one of the following tests:
- Physical Presence Test: You must be physically present in a foreign country or countries for at least 330 full days within a 12-month period.
- Bona Fide Residence Test: You need to establish that you have been a bona fide resident of a foreign country for an entire tax year.
The FEIE can be beneficial if your income doesn’t exceed the exclusion limit. However, the exclusion applies only to earned income, so investment and other passive income are not covered.
Foreign Tax Credit (FTC)
The Foreign Tax Credit (FTC) provides a credit for taxes you’ve paid to a foreign government, which helps reduce double taxation on your income. For example, if you pay income tax in France, you can apply for a credit on those taxes against your US tax obligations.
The FTC is particularly beneficial in countries with high tax rates, as it allows you to offset most, if not all, of your US tax liability. However, the credit does not apply to all types of income, and understanding how to maximize it can be complex. You can choose to claim either the FTC or the FEIE, but it’s crucial to analyze which option offers greater tax benefits based on your specific situation.
Social Security Taxes for US Expats
If you’re self-employed, you may still be responsible for paying self-employment taxes in the US, which cover Social Security and Medicare. For US citizens, the self-employment tax rate is 15.3%, regardless of where they live.
Totalization Agreements: To prevent double taxation on social security contributions, the US has agreements with certain countries. These agreements, called Totalization Agreements, ensure that self-employed individuals are not subject to social security taxes in both countries. Totalization agreements can significantly reduce or eliminate social security contributions abroad, so it’s worth checking if the country you’re residing in has one with the US.
Why do I owe US Taxes?
Even with available exclusions and credits, US citizens living abroad may still face tax liabilities for several reasons:
High-Income Levels: Exceeding the Foreign Earned Income Exclusion (FEIE) Limit
The Foreign Earned Income Exclusion (FEIE) allows US expats to exclude a portion of their foreign-earned income from US taxes, with an annual limit that adjusts slightly each year (e.g., $120,000 in 2024). However, if an American living abroad has an income exceeding this limit, the excess amount remains fully taxable by the US.
For example, let’s say an expat has a foreign-earned income of $150,000. With the exclusion capped at $120,000, the remaining $30,000 will still be subject to US taxes. If their foreign country has a lower tax rate than the US, they may owe US taxes on that excess.
Insufficient Foreign Tax Credit (FTC)
The Foreign Tax Credit (FTC) is another mechanism designed to prevent double taxation, allowing US taxpayers to receive a credit for foreign taxes paid on income earned abroad. However, the credit is subject to specific limitations and doesn’t always cover the full US tax liability. Here’s how this can play out:
- Lower Foreign Tax Rates: If an expat lives in a country with lower income tax rates than the US, the FTC might not cover their full US tax obligation. For instance, if an expat in a low-tax jurisdiction like Singapore or the UAE pays minimal or no income tax, they may still owe US taxes since their FTC won’t offset much of their liability.
- Different Tax Treatment on Certain Income: Some types of income may be treated differently by foreign tax authorities than by the IRS. For example, capital gains might be untaxed in a foreign country but still taxable under US rules, limiting the FTC’s ability to offset these US taxes.
Because the FTC can only offset taxes up to the amount of foreign taxes actually paid, expats may owe taxes to the US on income that is lightly taxed or untaxed abroad, leading to additional tax burdens.
Taxation of Investments
Foreign investments can create unexpected tax liabilities for Americans abroad due to the IRS’s complex rules on passive investments. Key considerations include:
- PFICs (Passive Foreign Investment Companies): Many foreign mutual funds, pensions, and ETFs are classified by the IRS as PFICs, which are subject to unique tax rules and often taxed at higher rates. Failing to report PFICs can lead to severe penalties, and even when reported, they can trigger higher tax liabilities.
- Foreign Retirement Accounts: While foreign retirement accounts may offer tax advantages locally, they often do not qualify for tax-deferred treatment under US law. This means the US may tax contributions or growth within these accounts, even if they’re exempt in the host country.
- Dividends and Interest Income: US expats with foreign investment portfolios may have to pay US taxes on dividends and interest earned on these investments, even if those earnings are exempted or deferred under the foreign country’s tax system.
These complexities around foreign investments can lead to hefty tax bills for expats, as well as increased reporting requirements, such as filing Form 8621 for PFICs and potentially paying additional tax on these assets.
Sale of Property
For Americans abroad, the sale of property can be another source of unexpected US taxes. Whether the property is in the US or overseas, the following factors apply:
- Capital Gains Tax: U.S. citizens must report and pay capital gains tax on the sale of property, regardless of where it’s located. This includes primary residences abroad, which may have different tax treatment in the US and the host country. In some cases, a home that qualifies for a capital gains exemption in the host country will still be fully taxable by the IRS if it doesn’t meet US requirements.
- Foreign Exchange Gains: If the value of the property appreciated due to currency exchange rates rather than actual market value, the IRS could still tax the gain as capital income. For instance, if an expat bought a property when the dollar was weak but sold it when the dollar was strong, the IRS might treat the currency gain as taxable income.
This treatment of foreign property sales can often come as a surprise to expats, who may have expected local tax laws to cover their tax obligations on the sale.
Income from US Sources
Even while living abroad, Americans must report and potentially pay taxes on US-sourced income. Common types of US income that remain taxable include:
- Wages from a US-based employer
- Rental income from property in the US
- Dividends or capital gains from US investments
- Royalties from intellectual property in the US
Since the FEIE and FTC don’t apply to US-sourced income, Americans abroad may have to pay full US taxes on this income without any foreign tax offsets. Expats earning from a US employer or maintaining investment accounts in the US should prepare for this additional tax burden, as it can lead to higher tax bills.
US citizens living abroad can face unexpected tax obligations due to the unique US approach of citizenship-based taxation, limitations on income exclusions, and differences in foreign tax treatments. Even with the Foreign Earned Income Exclusion, Foreign Tax Credit, and other tax benefits, many expats still find themselves owing US taxes, especially when their income exceeds exclusion limits or involves types of income not covered by these provisions.
Working with a tax professional specializing in expat tax law can make a significant difference. A qualified tax expert can help American expats understand the complex US tax rules, maximize available exclusions and credits, and develop strategies to reduce overall US tax liability.
