Taxes for Foreign Income

Digital Nomads Legality of Working

Tourists visas generally do not allow you to work in that country when visiting. Many country’s laws on this matter were established when employment required your physical presence to perform the job. Therefore laws haven’t caught up to a new form of location independent work that describes digital nomadism. This guide can not and does not in anyway endorse working digitally in a foreign country against the rules or regulations of that country. However, this guide wants to describe that digital nomads exist in a legal gray area that has not been properly defined by legal and tax statutes of most countries. This is quickly changing though as many countries are now adopting digital nomad visas which provide clarity on residency and tax requirements.

After obtaining a visa or establishing a permanent residency, following that country’s income tax rules becomes legally obligatory. Many countries have different tests to determine whether you would qualify as having a tax residence of that country. Some European countries determine tax residence with a simple rule stating you are a resident if you stay there for 183 days in a tax year. Other countries like Portugal will claim you have tax residence if your primary residence is registered within the country regardless of how long you stay there. It is important to research these rules before traveling and applying for a specific type of visa.

The Foreign Account Tax Compliance Act

Ciao has interviewed many digital nomads to compile this guide. One of the biggest misconceptions about tax compliance is that once moving to another country permanently, one does not have tax and filing obligations to the U.S. Not only do U.S. citizens or green card holders have to file annual tax returns in the U.S., they also have report the assets they hold in other countries.

In 2010 a federal law, the Foreign Account Tax Compliance Act (FATCA), was enacted to prevent global tax evasion. Part of this regulation is to force banks around the world to report the holdings of U.S citizens. Additionally, the law requires U.S. citizens to self report their foreign assets allowing the IRS to cross-check and verify the asset amounts.

If you have foreign assets greater than $10,000 you will have to annually file an FBAR form directly with the Financial Crimes Enforcement Network (FinCEN), a bureau of the Department of the Treasury, separate from the IRS. In addition, If you have financial assets outside of the U.S. totaling more than $50,000 you will have to report these assets to the IRS using Form 8938, Statement of Foreign Financial Assets If you are required to file these forms and don’t comply you would be subject to potential maximum penalties of 50% of your account holdings and $60,000 respectively. You could also face additional criminal penalties. For more information about when you have to file, please reference the IRS requirements

Foreign Earned Income

Once you have a tax residence in another country, you will have to file your annual tax using the procedures of that country. At the same time, you will want to minimize the amount of income taxes you owe to the IRS to avoid double taxation. There are two strategies a tax professional will use to accomplish this goal: the Foreign Tax Credit (FTC) or the Foreign Earned Income Exclusion (FEIE). You may use both strategies in tandem, but you can not use both the tax credit and exclusions against the same earnings. Additionally, these strategies only apply to earned income

What is the U.S Foreign Tax Credit?

The Foreign Tax Credit (FTC) is method that you are eligible to claim once you have paid foreign income taxes on foreign earned income. The taxes you pay can be used as a credit for your U.S. tax obligation. To qualify for this credit, the IRS applies four tests to your foreign tax.

1  “The tax must be imposed on you”
This generally means that a foreign country must be responsible for enforcing the tax on you. For example, if a foreign country is automatically deducting taxes from your employer’s paycheck this would be considered to be imposed.

2  “You must have paid or accrued the tax”
You can only claim the credit if you have already paid or accrued the foreign tax. If you haven’t paid it, accrued it, or bear responsibility for it, you won’t qualify for the credit.

3  “The Tax Must Be the Legal and Actual Foreign Tax Liability”
The tax credit you are claiming must be a legal tax. For example, if you pay a tax that is later refunded to you by a foreign country, you may not claim the initial tax contribution as credit for the FTC. The only tax that qualifies for the credit are those that are reduced by any refunds you receive.

4  “The Tax Must Be an Income Tax (or a Tax In Lieu of an Income Tax)”
You may only apply a credit for a foreign tax on income or excess profits. This is generally meant to mean that by paying the tax you do not stand have a specific benefit by paying the tax. For example, if you pay a foreign tax as way to balance a foreign tax credit owed to you, you can not qualify this tax towards reducing your tax obligation under the FTC. There are more specific rules in this case for when you can not apply the credit that can be referenced on the IRS site

If these rules apply to your foreign income tax you can use your tax payment as a credit to reduce and potentially eliminate your U.S. taxes. It’s important to do your research and consult tax professionals whether these rules apply to your situation. As an example, for many years the IRS did not allow U.S. expats in France to claim a foreign tax credit for their contributions to the “Generalized Social Contribution Tax”. In 2019, after several years of legal battles, the IRS finally allowed this French tax to be included and applicable under the fourth test of the FTC. Tax professionals will be able to assess the legalities of which credits will qualify under the IRS guidelines, thereby mitigating costly penalties.

What is the U.S. Foreign Income Exclusion?

Another method expats can use to reduce their tax is the Foreign Earned Income Exclusion (FEIE). If you meet certain requirements, you may exclude your income from your U.S. income tax obligation. In 2021, the IRS allowed a maximum exclusion to $108,700 of your foreign income to be completely excluded from U.S. income tax. This amount is adjusted every year and depending on how much consumer inflation occurs within the year.

One additional exclusion for the FEIE is your foreign housing expenses. The general logic for the calculations will be explained here, but for more detailed calculations please reference the example below or the IRS instructions that detail the specific rules. To use this exclusion your housing costs must be greater than what the IRS defines as the base housing amount. The base housing amount is 16% of the maximum FEIE exclusion stated above. In 2021, the base amount was equal to $17,392 (16% * 108,700). Therefore if your housing expenses were $18,392 for the entire year you would be able to claim $1000 (18,392 - 17,392) to be excluded for your U.S. tax obligation. Keep in mind that only certain housing expenses such as rent or utilities would apply as exclusions, whereas others like mortgage payment and internet utility would not. Lastly, if you are self employed you would not being using a housing exclusion. Instead you are required to use a deduction by deducting housing expenses from your gross income.

Requirements for the Foreign Earned Income Exclusion

Not everyone can claim the FEIE. To claim these tax benefits you must have earned income in a foreign country and must be either:

• A U.S. citizen or a green card holder who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive month. This is called the physical presence test.
• A U.S. citizen or green card holder who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year. Unlike the physical presence test, the bona fide residence is a subjective test of how strong your social and economic ties are to the foreign country. The IRS determines if you qualify on a case by case basis, strongly considering family ties and the intended purpose of your trip.

Which Tax Mitigation Strategy is Best to Use?

The best strategy to use is dependent on many factors: your personal tax qualifications, your foreign country residence, how much income you’ve earned, how you’ve earned your income, and what your expenses have been for the tax year. A general rule for starting your tax analysis is to consider the foreign country’s income tax rate in comparison to the United States. If the foreign country’s tax rate is higher, the FTC might be better. In this case, your foreign credit will completely clear your U.S. tax obligations. If the foreign tax rate is lower, then the FEIE might yield better results. Additionally, the FTC generates credit carryovers for future years which many expats enjoy the benefit of even after moving to lower tax countries. One problem many of our expats and digital nomads have faced is the legal nuance and rules of the FEIE. If you were personally filing your returns it is possible to make mistakes on the FEIE to nullify your claim causing penalties with accrued interest. These challenges make it worth consulting with an expat tax professional who will be able to analyze your situation and optimize your income tax savings. We provide examples below as reference for how the calculations work.

Simple Example of Expat Tax Options

Situation: Ruby is a U.S. citizen that has been living as a resident in Zagreb, Croatia for the entire year of 2021. Her annual salary is $150,000 paid by her U.S. based employer for the work she performed while living in Croatia. Her Croatian housing expenses were $25,000. For simplicity, we will say Croatia’s effective tax rate is 30% for Ruby’s income tax bracket. What strategy should Ruby use for her U.S taxes?

In this simple case, Ruby should elect to use the Foreign Tax Credit. She has paid more income taxes to Croatia than she would have to the U.S. and can carry over additional credit to future years if electing the FTC.

Tips to Successfully Planning Your Expat or Digital Nomad Taxes

• Make sure to properly track your time, income, and expenses in a foreign country. You can nullify your FTC or FEIE by not being able to provide detailed records for qualifications to tax income.
• Once invoking the FEIE, you use it until it is revoked. However, revoking the FEIE should be very carefully considered as the IRS will require written approval to remove the revocation.
• Self employment taxes have slightly different rules. The FEIE will reduce your regular income tax, but not your self employment tax. When speaking with a tax professional during an initial call, you should discussing how structuring your employment or business before the tax year can minimize your tax burdens.
• Although this article doesn't delve into state taxes, they are still a consideration. States can only impose tax on those with a "domicile" in the state. California and Virginia are two of the more aggressive states, trying to maintain taxing jurisdiction over their ex-residents. California, for instance, does not even recognize the FEIE.