As a basic rule, U.S. citizens, even those residing outside the United States, are considered to be U.S. residents for tax purposes and are therefore subject to U.S. tax reporting on their worldwide income. The unique status of being a resident in a foreign country but still a tax resident in the United States poses a number of challenges for the U.S. expat, some of which have particular relevance during an expat’s first year abroad.
In this article, we outline five key U.S. tax considerations for U.S. expats during their first year abroad. Familiarity with these considerations can help expats avoid tax traps for the unwary.
Qualification for the Foreign Earned Income and Housing Exclusions
Provided that an individual is able to establish that his or her tax home is outside the U.S. and can satisfy either the “bona fide residence test” or the “physical presence test,” such individual can exclude a portion of income earned overseas. “Earned income” includes income in the form of compensation (whether from employment or self-employment) but does not include income from investments, such as interest, dividends, capital gains, pensions and rental income. Expats can also exclude (for wage earners) or deduct (for the self-employed) from their gross income their housing cost amount in a foreign country, provided they qualify under the bona fide residence or physical presence tests.
Of the two tests, the “physical presence test” is the more straightforward test and requires presence in a foreign country or countries for 330 full days during any period of 12 consecutive months. The “bona fide residence test,” in contrast, looks to the surrounding facts and circumstances to determine if the taxpayer is properly considered a resident of a foreign country or countries for an uninterrupted period that includes the entire tax year.
Importantly, under the physical presence test, the 330 days do not need to be consecutive nor do they have to be in the same tax year. For taxpayers who move abroad in the middle of the year, the portion of the year spent overseas can be straddled with the second year overseas in order to meet the 330-day requirement. Utilizing a portion of the exclusions in such manner can lead to significant tax savings during an expat’s first year abroad.
Expats who need additional time to meet either the bona fide residence test or the physical presence test to qualify for the foreign earned income exclusion and/or the foreign housing exclusion or deduction, can request a tax return extension by filing IRS Form 2350, which is due by April 15 following the tax year.
Contributing to Your U.S. Pension While Abroad
In many cases, expats will continue to contribute to their U.S. pension at least during their first year abroad. As a general rule, an expat’s contributions to a U.S. pension (e.g., IRA) continue to be tax deductible while abroad.
The major catch, however, is that contributions to an IRA must come from “earned income,” as described above. Thus, a person cannot contribute income excluded under the foreign earned income or housing exclusion to an IRA.
In such case, expats should consider using foreign tax credits to reduce or eliminate taxable income, if such credits are available.
Deductibility of Moving Expenses
There are two aspects of moving expenses that can be tax beneficial for U.S. citizens moving abroad – first, the deductibility of self-incurred moving expenses, and second, the exclusion from income of employer reimbursements of moving expenses.
Expats may be eligible for a deduction for self-incurred moving costs (such as transportation of household goods and personal transportation) if, following a work-motivated move, the individual continues to work as a full-time employee in the new workplace for at least thirty-nine weeks during the twelve months after the move. In some cases, a deduction may also be available for storage expenses associated with the foreign move.
Expats may also be able to exclude from income moving expenses reimbursed by an employer. Qualified moving expenses (i.e., expenses that would be deductible if directly paid or incurred by the employee) are excludable as a fringe benefit to the employee. Otherwise nonqualified moving expenses (for example, meal expenses) for a move to a foreign country can generally qualify for the foreign earned income exclusion.
It should be noted, however, that under recently-enacted tax reform legislation (the so-called “Tax Cuts and Jobs Act”), starting with the 2018 tax year, the exclusion for moving expense reimbursements and the moving expenses deduction will no longer be available. The 2017 tax year, therefore, is the last year to take advantage of these tax benefits.
Breaking Residency with Your Former U.S. State
If an individual is a resident of a particular state and then moves abroad, such individual will most likely be treated as a part-year resident for the year of the move and will most likely be required to pay tax at least on the portion of income allocated to the period in which they were a resident. The critical question then becomes whether the state will tax the remainder of the year and subsequent years even though the expat no longer lives in the state.
The answer to this question varies by state, with three general attitudes currently prevailing:
In the most tax-friendly states, an income tax is not imposed altogether, so expats need not worry about state income tax when moving abroad from these areas. They include Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.
In the least tax-friendly states, the requirements for breaking residency are fairly strict and require not only that one move out of the state but also sever other ties they have with the state. Such ties include selling property owned in the state, closing bank accounts and even relinquishing a state-issued driver’s license. These states include California, New Mexico, South Carolina, and Virginia.
Most of the remaining U.S. states lie somewhere in between. In many of these states, the general rule is that if an expat has been outside of the state for a certain amount of time (e.g., 6 months) and can prove residency outside of the state, then he or she can cut tax ties with the particular state. Once non-residency is established, then income that is not sourced to that state will generally not be taxed by such state’s taxing authority. Of course, state-source income (such as the sale of real estate located in a particular state) can remain taxable even after tax residency has been broken.
Retaining Your U.S. Accountant While Abroad
Retaining your U.S. accountant to assist you with your U.S. tax filings while abroad, including your first year abroad, may come with certain risks. Expats should be aware that a U.S. accountant with little experience in the international tax arena may not be adequately familiar with all of the particular tax rules and reporting requirements that apply to the unique tax profile of a U.S. citizen abroad.
Every expat taxpayer’s circumstances are unique and should be addressed thoughtfully and thoroughly, especially with respect to the first year abroad. Considering the IRS’s particular focus on offshore tax evasion in recent years, staying on top of your U.S. taxes should be a high priority while living overseas.
Joshua Ashman, CPA, and Ephraim Moss, Esq., are co-founders of Expat Tax Professionals. They specialize in the areas of international taxation and U.S. expatriate taxation, and have extensive experience with international compliance and U.S. expat tax returns.