The Complete Overview to US Taxes on Foreign Income

It may come as a surprise to you, but only two countries in the world tax its residents on worldwide income:

  1. United States
  2. Eritrea

Despite being a developed country, the US has managed to group itself with an African country that appears to “intimidate emigrants into paying taxes.”

If you’re a new immigrant to the US, the IRS welcomes you… and the entirety of your foreign income. The same goes to current US citizens and resident aliens.

And if you’re an American expat now living in other countries, expect your earnings to be taxed regardless of where you stay. You must also continue to file your tax returns yearly if you meet the filing threshold.

Why the US Taxes Its Citizens on Worldwide Income

Let’s take a quick look at history.

According to The Wall Street Journal, the taxation on worldwide income first came about in 1861 during the American Civil War. It was a 5% tax on income earned in the US by citizens living abroad, and was done so that rich citizens would not avoid their military and civic duties during the war.

Then in 1864, the scope of the tax was expanded to include all income sources anywhere in the world. It hasn’t changed much since.

Resident Status: Resident Alien vs. Nonresident Alien

If you’re a US citizen or resident alien, you’re considered a US resident and would be taxed for income from foreign sources.

Things get a bit more complicated if last year was the first year you moved to the US. You’d have to first determine if you meet any of the following two tests that would decide whether you can be considered as a resident alien:

Monopoly's Income Tax Space: Pay ₤200

Image from Images Money / CC BY

If you don’t meet any of the two tests, you’re a nonresident alien. You also don’t have to pay taxes on your worldwide income or declare your foreign financial assets with FBAR.

Even if you’re a nonresident alien, if you’re married to a US resident alien or citizen, you can elect to be treated as a US resident for that tax year. It may be advantageous to you to use the Married Filing Jointly filing status to take advantage of various deductions, credits, and a possibly lower tax bracket for you.

To do this, however, you would have to file a paper return and attach a statement to your joint tax return containing the following information (according to the IRS):

  1. A declaration that one spouse was a nonresident alien and the other spouse a U.S. citizen or resident alien on the last day of your tax year, and that you choose to be treated as U.S. residents for the entire tax year
  2. The name, address, and identification number of each spouse. (If one spouse died, include the name and address of the person making the choice for the deceased spouse.)

Click here to download a sample letter to make the election (for the nonresident alien to be treated as a US resident on the joint tax return).

Forms for Taxes on Foreign Income

There are several tax forms you may want to look into if you want to properly declare your foreign income and maximize possible credits and tax savings as a US citizen or resident alien:

Form 2555, Foreign Earned Income Exclusion

In order to qualify to exclude your foreign earned income (which doesn’t include unearned income like dividends or interest), you must meet both of these tests:

  1. Tax home test
  2. Bona fide residence test or physical presence test

There are very specific examples in the three links above that I’d encourage you to visit as these tests may be a little confusing.

On top of your foreign income, if you’re an expat working abroad, you can also claim an exclusion or deduction on foreign housing expenses.

Form 1116, Foreign Tax Credit

If you’ve paid or accrued foreign taxes (via tax withholding, for example), you may choose to take a credit or itemized deductions on these taxes. Most of the time, you’re better off taking the credit.

This would allow you to avoid being taxed too much on that same foreign source income (anything from wages to dividends). However, if the US tax rate is higher than the foreign tax, you would still have to pay the additional taxes to the IRS.

For instance, if you’ve paid or accrued $1,000 worth of foreign taxes on your foreign wages and the IRS wants to tax you $1,500 on the same foreign wages, you can choose to take a foreign tax credit to avoid paying the full $1,500. Instead, you’d just have to pay the remaining $500 to the IRS.

Form 1099-DIV or INT

If you have any foreign financial assets that are paying you interest and dividends, you’d have to file Form 1099-DIV or 1099-INT but without filling up the Payer’s Federal Identification Number.

These information would then be transferred to Schedule B, Interest and Ordinary Dividends.

Form 8938, Statement of Specified Foreign Financial Assets

You’d need to file Form 8938 if your foreign financial assets exceed a reporting threshold. The latest threshold may be found here.

FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR)

This is a mouthful to pronounce, but it’s more commonly known as FBAR. If your foreign financial assets exceed $10,000 at anytime during the tax year, you’d have to file an FBAR online. This is not filed together with your tax returns.

I’ve written about this in length on a previous post.

How to Calculate the Exchange Rate

Exchanging Euros to Singapore Dollars

Image from epSos .de / CC BY

All foreign source income reported on your tax returns must be converted to USD.

To do this, you must use the prevailing exchange rate “when you receive, pay, or accrue the item.” You may use Yahoo Finance or XE to get the historical exchange rate.

You should create a spreadsheet to ease your calculations, and save the resulting document in case you get audited. Google Drive or Evernote are great options.

In Closing

A citizenship-based tax is outdated and places an undue burden on new immigrants and citizens living abroad. More and more US citizens have renounced their citizenship to avoid what is considered as an unfair tax obligation—the most notable person being Eduardo Saverin, the billionaire co-founder of Facebook who now lives in Singapore.

Until something changes, we’d all do well to adhere to these legal obligations if we choose to stay in the US.

If you have any questions or feedback, feel free to comment below.

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