10 Proposed Tax Reform Changes & Impact On Americans Living Abroad (Expats)
1. No change to citizenship based taxation (CBT): First and most important - under the current House proposal the Worldwide Taxation system of the Individuals residing abroad would not change. The Foreign Earned Income Exclusion (FEIE) and Foreign Tax Credit (FTC) remain intact.
2. Potential for higher tax: Potential for higher tax for taxpayers with children in low-tax or no-tax countries. Despite doubling the standard deductions, this group of taxpayers will be negatively affected by elimination of personal exemptions.
Working example -- UAE:
US taxpayer, married to non-US citizen, resides in UAE in a private house, has two dependent children. In 2016, from a salary of $130K, the taxpayer was able to exclude $101,300 through FEIE & standard deductions and personal exemptions for 3 people totaled $18,500. After calculations, the remaining US taxable income was $200.
3. Increased child credit, but families with children may be worse off: Increased child tax credit from $1,000 to $1,600 per child (even with proposed increase to $2,000 per child) does not compensate loss of personal exemptions. For qualifying households, child tax credit of $1k per child was available in addition to personal exemptions. Increased amount of credit per child of $1,600 now replaces the personal exemption of $4,050 but this credit is available only to those who qualify.
In 2017, the phase out income threshold was $55,000 for married couples filing separately; $75,000 for single or head of household filers; and $110,000 for married couples filing jointly. Unless the threshold for child credit is raised, families with children will face increase in taxable income.
4. Elimination of moving expenses deduction: common for Americans residing abroad, these expenses will no longer be deductible. This change will increase state taxable income too since moving expenses deduction reduced state taxable income as well.
Working example -- New York City resident moves to Japan for work assignment
Move occurs in December 2016. Total cost of airfare, transportation and storage of personal items was $10K. Taxpayer’s federal marginal tax rate was 25%; New York state and city marginal tax rate were 10%.
Prior to the proposed changes, the deduction of moving expenses saved the taxpayer $3,500 net between federal and state tax. This valuable tax saving deduction will be lost under the new rules.
Secondly, if the employer were to reimburse the employee’s moving expenses, this reimbursement, under the new rules, will be taxable income to the employee.
5. More itemized deductions eliminated: mortgage interest deductions for second homes, unreimbursed employee expenses, medical expenses, state and local tax payments, and loss and casualty deduction. Upon curtailing of itemized deductions the doubled standard deductions will be a better option for the majority of taxpayers.
Working example -- Married couple with mortgage
In 2016, the couple deducted $12K in mortgage interest, $8K in property taxes, $10K in state and local taxes, and $3K charitable contributions - a total of $33K itemized deductions.
Under the new rules, the couple can deduct $10K mortgage interest, 8K property taxes and $3K charitable contributions - a total of $23K. In 2017, with the standard deduction doubled, taking $24K of standard deductions is a better option for them than itemizing, but in the end they have lost $9K in deductions compared to the prior year. They have also lost $8,100 in personal exemptions.
As a result the couple’s taxable income is $17,100 higher (all else being equal).
6. Stock options taxable upon vesting, not exercise: Any compensation deferred under a nonqualified deferred compensation plan will now be included in income by the employee when the deferred compensation vests.
7. Big alimony changes: Payment will no longer be deductible to the payor, nor included in taxable income of the recipient. Specifically for expats, this would negatively affect those who pay alimony to a non-resident alien spouse. This will blur the difference between alimony paid to in the country with the treaty exemption and countries without the tax treaty. No alimony payment will be deductible in either case.
Working example -- US citizen residing in Switzerland pays $50K alimony to former spouse residing in Germany.
Due to the tax conventions, in 2016 the taxpayer was able to deduct $50K from his U.S. taxable income even if the spouse is a non-US person and does not file a U.S. tax return.
8. Changes to sale of property exclusions: Exclusion of capital gains on sale of main home would be allowable only if the taxpayer lived in the residence for five of the previous eight years, instead of two out of five years under the existing rules.
Exclusion would be phased out by one dollar for every dollar by which the taxpayer’s adjusted gross income exceeds $250,000 ($500,000 for married couples).
9. Self-employment tax would be applied to the partner/owner portion of income of partnerships and S corporations (whether or not it was distributed). Self-employment tax will also be applied to the income of limited partners of partnerships. This change brings up an interesting question; will this income will now be treated as employment income and qualify for the foreign earned income exclusion?
Working example -- Single owner of US S-corporation
Taxpayer reports $30K of passive income from the S-corp after paying himself a salary of $50K. Under the existing rules he pays income tax on $80K but social security and medicare tax are applied only to the salary portion ($50k).
Under the new rules social security and medicare tax will be applied on all $80K of net corporate income.
10. Repeal of AMT: There is one piece good news at the end, but to be fair, after the other proposed changes, AMT would be rare anyway. The main reason for the AMT was the instance of high itemized deductions, which for the calculation of AMT were ignored. As detailed above, curtailed itemized deductions remove the trigger for AMT because it will be no longer possible to deduct “too much”.