If you are here then chances are you are an U.S. expat or simply an American citizen living abroad looking for ways to reduce taxes on foreign income. It’s actually easier to do than most would think, by taking advantage of deductions, tax treaties and other benefits at your disposal.
In this article, the team at Quilca CPA Group will show you how to reduce taxes on foreign income with 5 smart strategies.
#1 – Claim the Foreign Housing Exclusion
You can also exclude your housing costs when living abroad thanks to the Foreign Housing Exclusion. You can exclude these expenses on your gross income on their US federal tax return, allowing you to reduce taxes on your foreign generated income.
You can use the Foreign Housing Exclusive to exclude the following housing expenses:
- Rent
- Rental of Furniture
- Parking
- Utilities (gas, electricity, water, etc.)
- Home insurance
- Home repairs
- Rental repairs
To claim this exclusive excursion, your tax home needs to be in the same country where you are living right now. Furthermore, you also need to be a tax resident in the foreign country for the entire tax year, and you must present for at least 330 full days in a calendar year.
If you have found out that you meet the substantial presence test and you’re a resident alien in consequence, you can also take advantage of the Foreign Housing Exclusion. This is a typical situation for E-2 investors, and hence it’s a good idea to seek out advice from a tax professional.
#2 – Use Tax Treaties for Your Benefit
Did you know that you can take advantage of existing tax treaties to massively reduce your taxes on foreign income? These formal agreements between the United States and your country of residence or nationality will help you to prevent double taxation on your foreign-generated income.
Tax treaties therefore will benefit U.S. expats and resident aliens in the US, because they will allow you to reduce your taxes on foreign income and even apply exemptions. However, such exemptions and reduced rates will vary depending on the tax treaty and your country of residence/nationality.
It is important to analyze your situation with a tax professional because some tax treaties have a clause known as the “saving clause”, which enables countries to tax their citizens as if no tax treaty existed. Resident aliens are the most affected by this problem because they might not be able to claim the tax benefits any longer.
You also need to take into account that the United States does not have tax treaties with all countries. In such cases, you will have to resort to solutions such as the Foreign Tax Credit, to show the IRS you have paid your taxes in your country of residence, and hence they will bring you a credit for every dollar you owe. This is only available for U.S. citizens.
#3 – Take Advantage of the Foreign Earned Income Exclusion (FEIE)
Did you know that you can save up to $120,000 in taxes by using the Foreign Earned Income Exclusion? You can exclude taxable income you are earning in a foreign country, such as a salary, commissions, bonuses, wage, etc. Making it an excellent solution for employed and self-employed U.S. citizens living abroad.
You need to meet the following requirements to quality for the Foreign Earned Income Exclusion:
- You must be a U.S. citizen or resident alien
- You must have lived in the foreign country for at least 330 days within the tax year
- You must work abroad
- You must meet the physical presence test or Bona fide residence test.
How to Calculate the FEIE: Formula and Practical Example
You can calculate how much you can exclude with the FEIE using this formula:
Your Maximum Exclusion Amount = [(FEIE limit for the year) x (number of qualifying days)] ÷ 365
Let’s fully grasp this concept with a practical example. The FEIE limit for 2023 is $120,000, and let’s suppose that you have lived abroad for 340 days during the tax year – using this information here’s the formula and the result:
Your Maximum Exclusion Amount = [($120,000) x (340 days)] ÷ 365 days
Your Maximum Exclusion Amount = [$40,800,000] ÷ 365
Your Maximum Exclusion Amount = $111,780
Simply replace the formula with your own data and you will easily calculate the maximum amount you can exclude when claiming the FEIE.
When the FEIE Might Not Help you
This is a great solution for U.S expats and resident aliens in the majority of cases. Nonetheless, if you have troubles proving your residence to the IRS, you have significant unearned income or you earn more than the limit set by the Foreign Earned Income Exclusion, then you should explore other strategies with a tax professional.
#4 – Claim the Foreign Tax Credit (FTC)
The Foreign Tax Credit (FTC) will allow you as a U.S. citizen to reduce your taxes on foreign income if you have already paid income tax on your country of residence. If there is a vague or no tax treaty, the FTC can be a powerful solution to reduce your taxes as an American living and working abroad.
Since it is a true tax credit as opposed to deduction, you can use the FTC to directly reduce your taxes. For example, if you have a foreign tax credit of $2,000, then it means that your tax bill will be reduced by $2,000. As opposed to deductions that work based on your tax bracket.
For example, let’s suppose that you owe the IRS $8,000 and you have claimed a foreign tax credit of $3,000 – then it means that you’d only have to pay $5,000 in U.S taxes ($8,000 – $3,000 = $5,000).
You should consult with a tax professional to know if your income will qualify for a FTC because the IRS has strict rules for claiming this tax credit. Furthermore, you also need to consider that there are limits for how much you can claim in tax credits.
Important note: You can claim both the Foreign Tax Credit and the Foreign Earned Income Exclusion. You only need to claim them on different types of income. This is another reason why working with a tax professional is the best decision you can make, to create a plan to reduce your taxes on foreign income effectively.
#5 – The Advantages of Contributing to a Retirement Account
Did you know that you can still get the tax benefits of contributing to a SEP, IRA or ROTH IRA? Even when you apply the Foreign Earned Income Exclusion, you can still make the most out of these contributions to your retirement account(s).
For example, contributing to an IRA will entitle you to a tax deduction each year if you meet the maximum contribution limits. This is the same case for a SEP or ROTH IRA. Even though it won’t be a big tax deduction, it will still help you to save money in the long run.
We recommend you consult with a tax professional to obtain more information about this, to create a plan that works for you as an U.S. citizen or resident alien that generates foreign income.
Who Can Take Advantage of these Strategies to Reduce Foreign Income?
It is easy to think that only citizens would be responsible for paying such taxes, and hence the only ones that can take advantage of these strategies. However, it will also apply to resident aliens (individuals who have met the substantial presence test) and even the spouses of resident aliens and U.S. citizens.
For example, let’s suppose that you’re an E-2 investor and you’ve met the substantial presence test by the IRS, and hence you’re classified as a Resident Alien. In this case, you will have to pay taxes on your US-sourced income and your foreign income.
This is a complex situation because if your E-2 business isn’t generating profits yet, then having to pay taxes on foreign income will only make your financial situation harder. This is why we recommend you to work with a tax professional when facing this issue, in order to see what deductions or exclusions you can use to reduce your tax burden.
Let Quilca CPA Group Help You Save Money on Foreign Income
If you want to reduce your taxes on foreign income but don’t know how to get started, then we can help you. We’ve already helped hundreds of U.S expats to reduce their taxes – call us now at (786) 310-5582 or send us a message at [email protected] to book a consultation.
