U.S. citizens and resident aliens are generally subject to the same tax rules whether they live abroad or in the United States: their worldwide income is subject to U.S. taxes. Those who work and live abroad may qualify for some special tax breaks. Most of the popular e-file tax reporting programs have sections explaining these rules. However, before you decide to move to another country, you’ll want to investigate whether you are likely to qualify for those benefits.
Citizens who have a “foreign tax home” can exclude some income and housing benefits from their U.S. taxable income. Generally, for purposes of the foreign earned income exclusion, your tax home is located at your regular place of business. If you regularly do business in more than one place and neither one is your “principal” place of business, your tax home is at your primary residence.
Simply maintaining a residence in the United States doesn’t make it your primary residence — this depends on where you live most of the time. However, there is an additional test: To have a foreign tax home, you must be either a U.S. citizen who has resided abroad for an uninterrupted period that includes a full tax year, or a citizen or resident alien who spends at least 330 days abroad in any 12 consecutive months.
If you have a foreign tax home and have spent at least 330 full days abroad — not necessarily consecutive — in any given 12-month period, you can exclude some of your foreign earned income and housing benefits from your U.S. taxable income for that period. The limit for 2009 is $91,400, and for 2008 it was $87,600.
Determining whether your income was “earned” or instead is considered investment income can be tricky, and particularly if the business is organized as a partnership or similar form recognized in the foreign country. If you invest and live abroad, and actively manage the investment full-time, a portion of your share of the business’s profits – up to 30 percent – may qualify for the foreign earned income exclusion. For example, if you own a house in Costa Rica, operate it as a bed and breakfast, and actively manage it, up to 30 percent of your business profits probably will qualify for the earned income exclusion. If instead you are a writer and live in the house alone or with your family, a portion of your earnings from writing may be excluded from your U.S. taxable income.
Rules for figuring the tax rate on the remaining portion of an expatriate’s income, after the exclusion is accounted for, changed in 2006. Under the current law, the tax on your non-excluded income is figured at the rate that income would be taxed if you don’t claim the exclusion. In effect, even though you don’t pay tax on up to $91,400 of your foreign earned income and housing benefits, the tax on the rest of your income will be charged at the marginal rate. (Note: If you live abroad and are still filling out your tax return as you did three years ago, you may want to consult a tax professional to help you straighten it out.)
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If you receive some of your compensation as housing benefits, you have another good reason to consult a tax professional. The rules for the foreign housing exclusion are very complicated, whether you work for a company or own your business. Complicating the matter further, if you live in a high-cost country or city, you may qualify for a higher foreign housing exclusion.
You may qualify, but should you claim the exclusion?
Even if you qualify for the foreign earned income exclusion, claiming it may not be to your advantage, and that may affect your decision about whether to move abroad. For example, according to CPA Max A. Koss, director of international tax services for Frost, PLLC, in Raleigh, N.C., “If you are earning income in another country, in many cases that country wants to tax that income. If the tax rate is almost the same as you would pay in the United States, you want to consider what meets your goals. The foreign earned income exclusion may not be as valuable as it sounds.”
Koss also noted that if you work for yourself, you will be liable for self-employment taxes even on amounts claimed for the foreign earned income exclusion. In addition, he said, “some countries’ rules say if you lived there for more than 183 days, you have to pay them taxes on your self-employment. You still have to report that income in the United States, and if there isn’t an employment tax treaty with that country, you could have to pay self-employment taxes in both places.” If the United States does have such a treaty with your country of residence, you may be able to choose which country to pay Social Security taxes to, he added.
Another factor to consider is that you may receive your income and benefits in a foreign currency, but you must report them in U.S. dollars when it comes time to file your U.S. tax return. “You are subject to potential swings in exchange rates, and you have to convert back to U.S. dollars,” Koss said. In addition, “for self-employment income, you’re going to use the average exchange rate for the year, and if you got most of your income when the rate was considerably higher or lower than the average for the year, this might change the picture for you.”
On the state level, Koss said, if you leave and have an intent to come back, you remain a resident during the time you are gone, and you may still be subject to that state’s income taxes. For expatriates without an intent to return to their state of previous residence, he advised, “If you keep your driver’s license and voting registration, or bank accounts, the state may conclude that you have an intent to come back. At the least, get a P.O. box in another state.”
Nick Hodges, president of NCH Wealth Advisors, tells of two clients who returned to Mississippi from a three-year tour in Spain. They filed their federal returns and claimed the foreign earned income exclusion, but “since they were not living in Mississippi, they figured there was no need to file Mississippi state tax returns. What they did not know was that not all states conform with the federal income tax law, and Mississippi is one of the few states that does not have a foreign income exclusion. When the State of Mississippi finally figured it out, not only did they owe back taxes, but the interest and penalties made the total amount more than twice the original amount.”
Hodges said another big mistake people make is believing that they don’t have to file a tax return if they don’t make more than the foreign earned income exclusion. “You can only take the exclusion by filing a return. If you are caught for not filing, you may not be allowed to use the exclusion,” he advised.
It’s a complicated area of tax law with many twists and turns. If you are contemplating moving abroad, you would be well advised to consult with a specialist in international taxation before making too many plans.