Cut Your Tax Bill To Zero
“The most important tool in the U.S. expat’s tax toolbox,” writes an international tax guru this morning, “is the foreign-earned income exclusion (referred to in tax-planning circles as the FEIE or ‘the exclusion’).
“If you qualify, it allows you to exclude up to $87,600 in 2008 foreign-earned income from U.S. federal income tax.
“All U.S. citizens and residents who earn more than $8,450 (single) or $16,900 (married filing a joint return) in a year must file a U.S. personal income tax return no matter where you reside.
“You must file, but that does not mean you must pay tax. One of the many benefits for an American of living or retiring abroad is that, once you’re a foreign resident, you’re eligible to take advantage of the FEIE.
“The exclusion applies to foreign-earned income only—that is, wages or self-employment income (independent contractor earnings, for example) you receive for services you perform while living outside the United States. Wages can come from a U.S. corporation or a foreign corporation, including an offshore corporation, and it does not matter if you are also a shareholder or owner of that foreign corporation.
“Note, though, that earned income does not include interest, dividends, or other investment or passive income.
“The key is to qualify. Bottom line, you qualify for the exclusion in one of two ways:
“1. The 330 Day Test. To qualify for the FEIE using the 330 Day Test, you must be outside the United States for 330 days out of any 365-day period. It does not matter if the 330 days are over two calendar years (between Nov. 1, 2007, and Oct. 31, 2008, for example), and you can avail of a special extension to file your tax return to give you time to meet this requirement.
“2. The Bona Fide Residency Test. In this case, you achieve foreign residency by moving to another country and making it your ‘home.’ You can intend to return to the States in the future, but you must move to the foreign country for an ‘indefinite’ or ‘extended’ period of time that must include one full calendar year.
“The 330 Day Test is fact-based, while the Residency Test hinges on your intentions and is therefore more difficult to use and to prove. I recommend relying on the 330 Day Test in the first year you claim the exclusion. Then you can move to the Residency Test.
“The Bona Fide Residency Test is one of the most misunderstood and misused sections of the U.S. tax code. You are a bona-fide resident of another country if you move there and make it your home. You show this, typically, by filing and paying taxes in that country.
“The perfect example of a U.S. foreign resident is a person who moves to a foreign country, does not intend to return to the States, files and pays taxes in the new country, obtains a long-term visa that allows him to work in that country, sells his U.S. home and buys one in the foreign country, and who relocates with his family.
“Of course, though, few cases are perfect.
“For example, a husband might move to France to work there indefinitely, leaving his family in California. Maybe he returns to the States for 40 days per year to visit and intends to return again full-time as soon as financially possible.
“In this case, the American in question has a good chance of being allowed the exclusion, assuming he is physically outside the States for at least one year, but it’s not guaranteed, and the determination by the IRS would depend on many facts and factors.
“Note that simply being out of the States for a full calendar year does not make you a resident of a foreign country. For example, if you go to a foreign country to work on a construction job for a specified period of time, say 14 months, you ordinarily would not be regarded as a bona-fide resident of that country, even though you’re living and working there for one tax year or longer. The length of your stay and the nature of your job are only some of the factors taken into consideration.
“If the residency test is so complex…you may be wondering…why should you use it? The biggest reason would be if you want to be able to spend more than 35 days a year in the United States.
“Furthermore, once you qualify as a resident of a foreign country, you remain a resident of that country until you give up that residency. With the 330-day test, you must be out of the country for 330 days of each 365-day period. In other words, the determination is made year by year.
“Plus, with the residency test, you can qualify for all or only part of a year. Here is an example from the IRS website:
“You were a bona-fide resident of England from March 1, 2006, through Sept. 14, 2008. On Sept. 15, 2008, you returned to the United States. Since you were a bona-fide resident of a foreign country for all of 2007, you also qualify as a bona-fide resident from March 1, 2006, through the end of 2006 and from Jan. 1, 2008, through Sept. 14, 2008.”
Also note that, if you’re married, and you and your spouse both are residing abroad, you each can take advantage of the foreign-earned income exclusion. Meaning you could be able to exclude up to your first $175,200 of foreign-earned income from U.S. tax.
Finally, as he points out, that the foreign-earned income exclusion is use it or lose it. If you don’t file your returns year by year, you can’t later go back and try to claim the exclusion. You’ll be required to pay U.S. tax on all your worldwide income for any year in which you failed to file.
P.S. One more note: The foreign-earned income exclusion applies to U.S. tax only. You can have a local tax obligation, as well, in the country where you’re a foreign resident. However, choose a zero-tax jurisdiction as your place of foreign residence…earn no more than $87,600 in foreign income each year…and you could reduce your overall tax bill to nothing. My best advice on all this, though, is: Don’t try to go it alone. A
P.P.S. Here are the top three zero-tax jurisdictions right now: Panama, Belize, and Uruguay.
“Kathleen,” writes friend and attorney here in Panama, “your readers have been contacting me to ask for clarification regarding this country’s recent changes to the residency visa requirements.
“Our immigration law was from 1960. When the law was first passed (under Noriega’s regime), the income/pension requirement was $500. This was meant to be revised by the government regularly. Finally, now, after nearly 50 years, we have done that.
“The forestry visa was the one most affected by the revisions, but, even here, the changes are not as great as some seem to fear. In fact, soon we will have options that will require only a small increase in the investment requirement.
“Most of this country’s other residency visas have been affected only marginally.”
FROM THE MAILBAG:
“Kathleen, I want to suggest that you cover a destination I never see on your website–Huatulco, Mexico.
“You sometimes mention Puerto Escondido, but never Huatulco, when, in fact, Huatulco is one of the most beautiful places in the world. Winner of the Green Global Award for its environmental-friendly attitude, Huatulco is one of Fonaturs’ pet projects.
“The area has 36 beautiful beaches, an international airport, and a cruise pier that receives 84 ships each year. The international airport supports many direct flights to and from Canada and the U.S. every week.
“If your readers want to buy or build a second home, they would be hard pressed to find a more beautiful, safe, and inexpensive place to invest. Property in Huatulco is half the price of property on the Mayan Riviera or in Los Cabos, for example.
“Huatulco has 3,500 hotel rooms right now, and Fonatur has a plan to increase that to 10,000 in the next 10 years. Now is the time to buy.
“I am a retired Canadian living in Huatulco, but I am always looking for new places to visit and invest. I read your newsletter almost daily and yet I never hear of Huatulco. I suggest you do your customers a favor and include Huatulco in your recommendations. It really is still an unknown paradise.”
— Lanny B., Huatulco, Mexico