How US expats living in low-tax countries can reduce their US tax bill
Ines Zemelman, EAAug-10-2016
Americans who live and work in low-tax countries and earn over the Foreign Earned Income Exclusion are likely to owe tax due because their US tax obligations exceed the taxes they pay locally.
There are, however, strategies that you can take to reduce or even eliminated the US tax bill under such circumstances. Below you will find 10 different routes to reduce U.S. tax bill while living in the low-tax country.
1. If you are married to a non-resident alien spouse, consider making an election to file jointly and report your spouse’s income on your joint tax return
At first glance, this advice is counter-intuitive. If you owe U.S. tax on your $130K salary, how could adding $100K of earnings from your spouse reduce your tax bill? Yet, it does. Treating your NRA spouse as a US citizen for tax purposes and adding them to your tax return upgrades your filing status from the heavily taxed Married Filing Separately to the preferential Married Filing Jointly.
Your standard deductions then doubles from $6.300 to $12,600 and you add a personal exemption for spouse of almost $4K. Thus an additional $10,300 will be deducted from the same combined taxable income because your spouse’s wages are excluded through their own Foreign Earned income exclusion. Instead of $20K taxable income while filing alone, you have now $10K taxable income while filing jointly.
Even if you live in a no-tax country and do not have any foreign tax credit to offset the remaining taxable income, your tax bill will go down from $6K to $2K.
2. If you are married to a non-resident alien spouse, and your spouse is a high earner, consider taking personal exemption for the spouse while filing Married Separately
If your spouse makes $120K or more, adding their income to your joint return will increase your combined taxable income. However, you can apply for an ITIN (Individual Tax Identification Number) for your spouse and claim a personal exemption of $4K for the non-resident alien spouse. This alone will reduce your tax bill by $1,350.
This option is available to expats at any income level provided that your spouse does not have income from U.S. sources. Their foreign income is not counted and does not affect your right for taking additional personal exemption.
3. Claim your children born abroad as dependents if they qualify for a Social Security number
Children born abroad to a U.S. parent may qualify for a U.S. Social Security number. Note that if they do qualify (consult with the U.S. embassy in your country of residence) then they will have U.S. tax reporting obligations anyway - and will have to apply for the Social Security number later, when they have income on their own. With FATCA in place, foreign banks have their own strategy and criteria to identify account holders with the U.S. roots.
If you take this step for them while they are still minors you will upgrade your filing status to Head of Household (as mentioned above, far better than Married Filing Separately). You will be able to take a personal exemption of $4K for each child and may qualify for other benefits, such as child credit, dependent care credit and credit or deduction for higher education expenses for yourself or your children.
Note that if your children do not qualify for a Social Security number, then they will not qualify as dependents even with ITIN - unless they spend at least 6 months in the U.S. during the tax year.
4. Other income deductions become available to you just by changing the filing status
Changing filing status through one of the methods described above will make you eligible for certain deductions not allowed for taxpayers under the Married Filing Separately status.
If you have rental property that generates loss, you can reduce your taxable income. However, you may not apply rental loss while filing Married Separately. $10K of rental loss will save you over $3K in U.S. federal tax if you file under a different filing status.
Annual amount of capital loss is limited to $1.5K for Married Filing Separately - half of the amount of capital loss allowed under other filing statuses. Respectively, tax reduction is also only a half of what could be taken annually.
5. Contribute to a U.S. IRA
Foreign employer retirement plans DO NOT PREVENT your voluntary contributions to the U.S. Individual Retirement Accounts (IRA). You can contribute up to $5,500 for yourself ($6,500 if you are over 50 years old) and the same amount for your spouse. Income reduction of $11K through $13K may eliminate your entire U.S. taxable income or reduce tax by $4K.
Note that if you receive income from a U.S. employer and participate in a U.S. employer retirement plan, such as 401(k) or 403(b), you cannot contribute to a Traditional IRA.
6. Eliminate self-employment tax
Affected individuals: self-employed taxpayers in countries without a Social Security Totalization Agreement. All low-tax countries do not have the Social Security Totalization Agreement with the U.S.
If you live in a country that has a Social Security Totalization Agreement with the U.S. then you are protected from duplicate contributions on net self-employment income. You pay only to the country of residence and receive an exemption in the U.S. However - if your country of residence has not signed such agreement with the U.S., then you end up paying to both systems. This puts additional burden on you because you also have to pay U.S. income tax.
To avoid a duplicate charge - consider incorporating your sole proprietorship. Then you will be considered an employee in your own company, and will no longer be subject to U.S. Social Security tax.
7. Consider renting over owning. While weighing your option of buying a house vs renting, do not overlook the U.S. tax considerations among other factors
Rental expenses can be excluded from earned income on top of the foreign earned income exclusion. Depending on the cost of living in your country of residence and the actual amount of rental expenses, you may exclude a significant amount - for some countries up to $100K on top of the foreign wages exclusion.
Mortgage interest also can be deducted, however it yields much lower tax saving than housing exclusion.
8. Optimize your earning structure by requesting that HR separates housing assistance on your employment contract as a separate line item
Employer-provided housing must be reported as a separate compensation item. If housing is not spelled out as a separate compensation item and blends into your total salary, your ability to exclude additional income is limited.
If you receive total $150K compensation, of which $100K is wages and $50K is compensation for housing, you will not be able to exclude housing expenses unless your employment contract or paystub stipulates this breakdown. If this is just a part of negotiations when you established payment terms with your employer, you cannot exclude more than $100K because the entire annual compensation is shown as wages.
Whereas if you have a written document that spells out $50K paid for housing expenses, then your exemption will be more than $100K and you will be able to exclude the housing allowance up to the IRS - allowed amount for your country and city.
9. Beware of U.S. State tax refunds. They will turn into a taxable income if you itemized your deductions in the prior year
Example: you file U.S. state return this year and receive $3K state tax refund.
If you itemized deductions, then $3K will be added back to your federal taxable income for next year generating $1K federal tax.
Ask your tax preparer how much you save now by using itemized deductions over standard deductions. If saving is less than $1K then you are better off using the standard deductions. When you claim standard deductions then state refund will not be taxable the following year although the refund amount will remain the same.
10. Think out of the box - tax saving methods unrelated to expat filing status
- Let’s imagine that you are single, have no children, and work in Hong Kong. You’ve paid off your mortgage and earn $400,000 per year. After the foreign earned income exclusion you owe $50K to the IRS in addition to $60K tax in HK. None of the tax saving methods above apply to you.
- You are in a perfect position to pursue aggressive investment strategies with high risk/return profiles. Short-term foreign exchange contracts like spot foreign exchange trades fall under Section 988 where gains and losses are taxed like ordinary income. An advantage of Section 988 treatment is that any amount of realized loss can be deducted in full on the annual tax return, while capital loss deduction is limited to $3,000.
- This is a win-win situation for you. If you make $30K profit, then you will pay $10K tax on additional income yet you will have extra $20K to partially cover IRS tax bill on earnings. If you incur a $30K loss - well, this will not make you poor after all but income deduction will reduce your existing IRS tax bill by $10K. This atypical situation creates an asymmetric risk-reward.
- Do not confuse forex trading with gambling. Gambling gains are similar to forex trading gains because they are also fully included in annual income. Yet, gambling loss can be deducted only to the extent of offsetting gambling income. Do not anticipate that tax deductions will alleviate frustration from gambling losses.
- The most righteous way of diverting tax money from the IRS and putting it to a better cause - contributions to charity. To be deductible, contributions should be made to a U.S., Canadian, Mexican or Israeli charitable organization. However, your options for making a difference in the world are not limited to those countries.
- You can look for an existing foreign organizations that acquired Sec. 501(c)(3) U.S. charity recognition and make contributions to it. See http://charity.org/.
- If you want to build a school or hospital in a remote area of the world that touched your heart yet not supported yet by any U.S. registered charity, you can create your own charitable foundation and register it as Sec. 501(c)(3) organization with the IRS. You and your friends can transfer money to the foundation and deduct contributions from your personal income. See this document for more information.