Expat Taxation 101—Everything The American Abroad Needs To Know
Yesterday, I mentioned that most tax loopholes for going offshore were closed with the U.S. Tax Reform Act of 1986. That is not to say that an American can’t still enjoy tax benefits by diversifying his life internationally. You can.
Your options today are limited, but the benefits can be significant. Unfortunately, most U.S. tax accountants don’t understand the rules as they relate to an American abroad, which is why I’ve done my own taxes for the last 14 years.
When my wife Kathleen Peddicord and I moved permanently out of the United States together, she suggested that we have her accountant, the one she’d been using for years, prepare our U.S. tax return. Although I’d worked in tax accounting offices and had prepared tax returns professionally at various points during my U.S. working life, I agreed. I thought it’d be simpler and save some time. We sent off all our tax information from Waterford, Ireland, back to Kathie’s accountant in Baltimore.
The polite way to explain what happened is to say that the tax accountant, a professional CPA with all the most current and comprehensive computer tax programs and reference materials at his disposal, screwed up our return and not just once. I sent it back to him three times to have sections redone. Only he kept insisting that the things I knew to be mistakes weren’t. Eventually, finally, he took the time to look up the relevant tax rules…and made the changes I’d been asking for.
Then he sent me a bill for three times what it should have been. That was when I decided I’d do my own taxes from then on. Why should I pay to train someone?
As I’ve mentioned, I have a tax accounting background. You probably don’t, so you probably don’t understand the international aspects of U.S. tax rules or how to apply them. Fair enough. The problem is that most U.S. tax accountants don’t understand the international aspects of U.S. tax rules or how to apply them either. The handful who do charge an arm and a leg to give you advice.
I had a question once about how to structure a real estate purchase I was making in Spain. The transaction was of enough value that I thought it best to get a second opinion on my intended strategy from a U.S. tax attorney. The question was simple, but the response was a dissertation that went on for seven pages, quoted verbatim parts of the IRS tax code, and, in the end, didn’t actually answer the question or provide any advice. It was accompanied by a bill for US$1,200 for the three hours it had taken the guy to write the useless seven-page memo.
This is the conundrum. The IRS’s revenue strategy seems to be to make the rules so complicated and the penalties for not following them so onerous that you can’t afford not to file the right forms at the right times. But the typical tax advisor either doesn’t know what he’s doing or complicates things only further to justify ridiculous fees. The average taxpayer, certainly the U.S. taxpayer overseas, can feel like he’s left holding the bag.
The thing that few U.S. tax professionals will tell you is the basic rules aren’t that complicated. The Foreign Earned Income Exclusion (FEIE), the primary tool for mitigating tax on earned income for the American abroad, is straightforward. You qualify by passing one of two tests–the Bona Fide Resident test or the Physical Presence test.
One tax attorney I spoke with years ago admitted to me that he didn’t bother with the Bona Fide Residency test. It was too complicated, he thought, to prove to the IRS, so he told all his clients that they could qualify for the FEIE only if they passed the Days test. The truth was that this tax attorney didn’t fully understand the rules himself.
The way for an American to qualify for the Foreign Earned Income Exclusion under the Bona Fide Resident test is by being a legal resident of another country. But there’s more to it. You have to really be a resident of that country. Having legal residency in the country and spending only four weeks a year there but the rest of the time in the United States (as some have done under the Belize QRP program) doesn’t qualify you for the FEIE.
You have to have an actual residence (rented or owned) in the country of residency. You have to be required to file a tax return in that country (whether you end up owing tax to the country is a different question). You have to show a connection to the country…a local driver’s license, family living with you, and no obvious or immediate intent to move back to the United States. Not having a residence in the States helps but isn’t absolutely necessary.
If you do qualify for the FEIE under the Bona Fide Resident test, you can spend more than 35 days in any 365-day period in the United States and still take advantage of the tax savings of the FEIE.
Under the Physical Presence test, the line is more black and white (hence the reason the tax attorney referenced above preferred it). If you’re physically outside of the United States for 330 or more days in a year period, then you qualify for the FEIE. Counting days can get tricky. If you transit the United States when flying from Europe to South America, for example, that counts as a day Stateside even if your connection time is no more than an hour. The advantage is that this test doesn’t require you to have legal residency in another country. This test works well for transient workers in the oil, construction, and security industries. Or the PT.
Qualify under one of these two tests, and you can exclude (not deduct) up to US$92,900 of earned income in 2011 and up to US$95,100 in 2012. The two keys here are that the income is earned and that it is excluded. Passive investment income doesn’t qualify. Retirement income (pension income) does not qualify.
The income is excluded from your tax return, which means it comes off the revenue side on page one of Form 1040 rather than on the deduction side on page two. Being excluded rather than deducted has a benefit, but also a negative. As an exclusion, rather than a deduction, it isn’t limited by deduction limitation rules. However, it reduces your taxable income from the bottom up. In other words, if you end up with US$10,000 worth of taxable income, that US$10,000 is taxed in the bracket for US$102,900. You would pay US$2,800 in taxes rather than US$1,079, filing as a single person.
If you’re renting overseas (rather than living in a home you own), you may also be eligible for the Foreign Housing Exclusion.
The really good news (that U.S. tax accountants would really prefer you never discover) is that you can do your own taxes as an American abroad, certainly if all you’re dealing with is the FEIE and the Foreign Housing Exclusion. All you need is TurboTax and a basic understanding of the rules as I’ve outlined them here.