Your tax filing obligations follow you worldwide. However, there are several tax rules to avoid double taxation and to lower your tax liabilities. Taxpayers should keep track of their worldwide financial transactions. There are 7 categories of income: 1- Section 951A basket, 2- Foreign Branch basket, 3- Passive basket, 4- General basket, 5- Section 901(j) basket, 6- Certain Income Resourced by treaty basket, and 7- Lump-sum distributions basket. A separate Form 1116 is required for each category of income.

Many financial transactions carry some tax consequences. The institutions that you transact with, national and foreign, are required to report the transactions to the Internal Revenue Service. The US Government has several conventions and agreements with foreign governments and institutions to combat money laundering and tax evasion. Among others, FATCA – Foreign Account Tax Compliance Act, FBAR – Foreign Bank Account Report, IGA- Intergovernmental Agreements, OECD- Organization for Economic Co-operation and Development; the J5- Joint Chiefs of Global Tax Enforcement. Penalties are often imposed for non-compliance because the application of the tax code is coercive.

Example of transactions with tax filing or reporting implications

  • As US citizens, resident aliens, or expats (leaving overseas), US tax laws require you to pay tax on your worldwide income whether the income is passive income, like investment in real estate or active income, earned income from a foreign country.
  • If you have signature authority, ownership interest in foreign accounts in total of $10,000 or more, you must report it.
  • If you have income from a foreign country, live in a foreign country, or conduct transactions in a foreign country you must keep record of the tax paid to the foreign country because you could claim the foreign earned income tax credit, the housing tax credit, or the foreign income exclusion. You must also keep records of your housing expenses because the records are needed to compute your housing credit. The allowable amount of credit varies by country.

U.S. citizens or resident aliens who live abroad are taxed on their worldwide income. However, they may qualify to exclude their foreign earnings from income up to an amount that is adjusted annually for inflation.

The foreign tax credit is intended to reduce the double tax burden that would otherwise arise when foreign source income is taxed by both the United States and the foreign country from which the income is derived. The tax must meet four tests to qualify for the foreign tax credit:

  1. The tax must be a legal and actual foreign tax liability
  2. The tax must be imposed on you
  3. You must have paid or accrued the tax, and
  4. The tax must be an income tax (or a tax in lieu of an income tax)

In general, only income taxes paid or accrued to a foreign country or a U.S. territory, or taxes paid or accrued to a foreign country or U.S. possession in lieu of an income tax, will qualify for the foreign tax credit.

Taxpayers may qualify to exclude foreign earnings from income up to an amount that is adjusted annually for inflation ($108,700 for 2021, $112,000 for 2022, and $120,000 for 2023).

The foreign tax credit limitation is limited to the pre-credit U.S. tax on foreign source income. It is the lesser of: 1) The foreign tax paid, or 2) The U.S. tax on the foreign income. The foreign tax credit limitation is there to prevent an offset of U.S. income taxes on U.S. income because the purpose of the FTC is to mitigate double taxation on foreign income.

In addition, they can exclude or deduct certain foreign housing amountsTaxpayers who are claiming a foreign housing exclusion must figure that amount first because the foreign earned income exclusion is limited to your foreign earned income minus any foreign housing exclusion you claim. The amount of qualified housing expenses eligible for the foreign housing exclusion or housing deduction is also limited. The limitation on housing expenses is generally 30% of the maximum foreign earned income exclusion. The limit will vary depending upon the location of your foreign tax home and the number of qualifying days in the tax year.

They may also be entitled to exclude from income the value of meals provided to them by their employers on their premises and for their convenience.

Key Highlights

  • When you exclude foreign housing costs or foreign earned income, you cannot take a foreign tax credit for taxes you paid in connection with the income that you exclude.
  • If the US has a tax treaty or convention with the foreign country, you could take advantage of the treaty or convention provisions. The tax rates are lower compared to non-treaty or convention countries. The rates vary and depend on the nature of transactions.
  • If you sold real estate property in a foreign country or received rental income, it is very important to take the currency conversion rates into account because you must report the income or payments in US dollars.
  • If you lived in your property in a foreign country for a least 2 of the last 5 years and you sold it at a gain, you could exclude $250,000 of the capital gain, if you are single, and $500, 000, if married filing jointly. There is no exclusion for rental properties and thus any amount of capital gain is taxable. Taxes and expenses in connection with the rental properties are deducted as business expenses.
  • If two married individuals work abroad and meet either the bona fide residence test or the physical presence test, each one can choose the foreign earned income exclusion.
  • Taxpayers who are qualified for the foreign earned income exclusion for only part of the year must adjust the maximum limit based on the number of qualifying days in the year.
  • Taxpayers’ reporting obligations could be very different. Taxation of individuals with foreign transactions or living in foreign countries are complicated. You are advised to consult a qualified tax professional for your specific case.

Beginning in 2021, two new schedules, B and C, are required to be attached to the Form 1116 if there are carryovers or carryback of excess foreign taxes, or if there are foreign tax redeterminations.

If you cannot claim a credit for the full amount of qualified foreign income taxes you paid or accrued in the year, you are allowed a carryback and/or carryover of the unused foreign income tax, except that no carryback or carryover is allowed for foreign tax on income included under section 951A. You can carry back for one year and then carry forward for 10 years the unused foreign tax. 

Further reading:

Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad

Publication 514, Foreign Tax Credit for Individuals

Hiring a tax resolution expert is the best action a taxpayer could take during an audit by the IRS or a state Department of Revenue. 

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