Did you know that foreign income is still taxed by the United States? Millions of Americans who earn money abroad or plan to earn money abroad should be aware of their tax obligations. The United States is currently one of the only countries in the world that taxes based on citizenship, and not residency. However, there are some exclusions and foreign tax credits that can reduce your tax liability. Overall, reporting foreign income can be tricky. Here’s an overview of how to report foreign income at tax time.
What is Foreign Income?
First, let’s clearly define foreign income. Foreign income is any income you receive overseas. This can include the following:
- Foreign wages: Foreign wages are wages paid to you for services rendered or goods sold. This can mean being employed by a foreign company or being self-employed but working abroad.
- Foreign interest and dividends: Foreign interest is money earned through foreign bank accounts. Foreign dividends are payouts from foreign-earned stocks.
- Foreign real estate: Foreign rental income is income earned on a property you rent out located in a foreign country. Alternatively, if you sell a property that is located outside the United States, you’ll need to report the gains or losses on the sale during tax season.
How Do I Report Foreign Income on My U.S. Tax Return?
If you earned foreign income, you would need to report it on Form 1040 when filing your tax return. You may also need to file other tax forms depending on what type of income you earned. For example, if you earned foreign interest and dividends, you’d report these on Schedule B of Form 1040. Foreign business income is reported on Schedule C. Most capital gains are reported on Schedule D. Rental property income is reported on page 1 of Schedule E. However, in more complicated tax situations, there could be additional forms to file, like Form 8938, Statement of Specified Foreign Financial Assets or Form 114, Report of Bank and Financial Accounts. In any case, you should speak to a qualified tax preparer about which forms your specific tax situation requires.
What is the Foreign Tax Credit?
Some taxpayers might worry about paying taxes twice on the same income. The Foreign Tax Credit (FTC) is one of two safeguards that help American taxpayers avoid this issue. This credit allows American expats, or U.S. citizens who live abroad, to offset foreign taxes paid abroad dollar-for-dollar. For example, if you’re an American expat who paid income taxes to the foreign country where you reside, the FTC gives you a tax credit to use on your U.S. income tax return.
Requirements
To claim this credit, you must be the following requirements:
- The tax must be imposed on you. This basically means that if your resident country does not require income taxes to be paid, you do not qualify for the FTC.
- You must be the one who paid or accrued the tax. This means if you have not paid the tax or accrued it, you do not qualify for the FTC.
- The tax must be the legal and actual foreign tax liability. This means that if the tax is not legal, and you are not required to pay it, you do not qualify for the FTC.
- The tax must be an income tax. This means that if the tax is another type of tax besides income tax, you do not qualify for the FTC. The IRS has specific rules on what they deem to be a foreign income tax. Be sure to check with your tax preparer for clarification.
How to Calculate the Foreign Tax Credit
Calculating your maximum FTC can be tricky, but essentially you can divide your foreign taxable income by your total taxable income (including U.S. income). Then take this quotient and multiply it by your U.S. tax liability. For example, if you earned $50,000 in Spain and another $10,000 in U.S. income, you’d have a total taxable income of $60,000. Let’s also assume you had a U.S. tax liability of $12,000. You would take your foreign income of $50,000 and divide it by your total taxable income of $60,000 to get 0.83. You would then multiply 0.83 by your U.S. tax liability of $12,000 to get your maximum FTC of $10,000.
Additionally, the FTC can carry over to the next tax year or carry back to a previous tax year. Unused FTC amounts can be carried over for up to 10 years. Taxpayers can claim the FTC by filing Form 1116.
What is the Foreign Earned Income Exclusion?
The other safeguard that helps American taxpayers avoid paying taxes twice on the same income is the Foreign Earned Income Exclusion (FEIE). The FEIE allows you to exclude all or some of your foreign earned income on your U.S. tax return, including salaries, wages, bonuses, commissions, and self-employment income. It does not include passive or investment income. The FEIE is available to U.S. expats who meet one of the following requirements:
- Work outside the United States as an employee
- Work outside the United States in a self-employed or partnership structure
- Pass the Bona Fide Residency Test. This requires being overseas for work for longer than one year and having a permanent place of work in the foreign country.
- Pass the Physical Presence Test. This requires living outside the United States for 330 full days out of the year.
U.S. taxpayers must use Form 2555 to claim the FEIE and can exclude up to $120,000 of foreign income for the 2023 tax year. The amount is due to increase to $126,500 for tax year 2024. Married couples filing jointly can exclude up to $240,000 as long as both spouses meet either the bona fide residency test or the physical presence test.
Help Reporting Foreign Income
Reporting foreign income can get complicated very fast. While this article covers several topics related to foreign income, it really is just the tip of the iceberg and applies to most simple tax situations. American taxpayers who live in the country, as well as expats, who earn foreign income should seek best practices regarding foreign income from reliable and knowledgeable tax professionals. If you need tax help, Optima can assist.
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