The top 10 expat tax issues when living in the U.S.
The following tax issues are relevant to expats living in the US (each is considered below):
- Mortgage deductibility
- Principal residence exclusion
- Property tax deductibility
- Passive property loss limitations
- Foreign currency gains on repayment of debt
- Currency gains on sale of foreign real estate
- Are you head of household, married filing jointly, and what does that mean?
- Selling US real estate as a resident or non-resident
- Tax equalization. What is it and how does it impact you?
A Taxpayer may deduct interest on debt incurred to acquire, construct or substantially improve a taxpayer’s main or second home in the US, and debt is secured by the home. US persons living abroad may also deduct mortgage interest on their main or second home outside the US.
The level of indebtedness on which home mortgage interest may be deducted is $750,000 or $375,000 if married filing separately (or if the indebtedness was incurred before December 16, 2017, $1 million ($500,000 if married filing separately)). The home must be a “qualified home” in which the taxpayer has an ownership interest – i.e. a main home or second home, which is a house, condominium, cooperative, mobile home, house trailer, boat, or similar property that has sleeping, cooking, and toilet facilities (see IRS Publication 936).
If a second home is rented out, it must be used for more than 14 days, or more than 10% of the number of days it is rented out (whichever is longer), in order for the mortgage interest to be deductible.
Principal residence exclusion
A gain of up to $250,000 ($500,000 if married filing jointly) may be excluded on the sale of a principal residence (your main home) located in the US.
The gain is calculated by subtracting the adjusted basis (costs associated with the purchase and maintenance of the home) from the amount realized (being the selling price less selling expenses) from the sale.
Gain = Amount Realized – Adjusted Basis
Generally, in order to be eligible for the exclusion the following conditions must be met:
- you are not automatically excluded by:
- the home having been acquired through a like-kind exchange (1031 exchange) in the past 5 years; or
- you being subject to expatriate tax (by relinquishing US Citizenship);
- you have owned the home for at least 2 out of the 5 years preceding the date of sale / closing (for a married couple filing jointly, only one spouse need meet this requirement) (ownership requirement);
- you used the home as your residence for at least 2 out of the preceding 5 years (residence requirements). Each spouse must meet the residence requirement in order for a married couple filing jointly to get the full exclusion; and
- you didn’t sell another home during the 2 years preceding the date of sale, or alternatively, you didn’t exclude the gain from such a sale in that period (look-back requirement).
There are specific exclusions for separation and divorce and the death of a spouse. Additionally, partial exclusions apply for changes in workplace location, health issues, and unforeseeable events.
- you are not automatically excluded by:
Property tax deductibility
State and local real property taxes that are based on the value of real property and levied for the general public welfare, are generally deductible, both on a principal residence and on a second residence.
The deductible amount is capped at $10,000 (or $5,000 if married filing separately), and excludes taxes charged for local benefits and improvements that directly increase the value of the property (for example, sidewalks, water mains, sewer lines, parking lots, and other such improvements), or charges for services to specific properties and people, even if paid to the relevant taxing authority.
Alternative Minimum Tax (AMT)
The operation of the AMT rules requires consideration if you are a high income earner or exercise or hold incentive stock options and private activity municipal bonds. The AMT is a tax is imposed on individuals, estates and trusts, instead of the regular Federal tax.
Taxpayers are required to calculate their liability twice – for both the regular federal income tax liability and under the AMT rules—and pay the higher amount.
The AMT disallows the personal exemption and “adds back” deductions such as state and local tax deductions, interest on private-activity municipal bonds, bargain elements of incentive stock options, foreign tax credits, and home equity loan interest deductions (mortgage home loan interest and charitable donations are still deductible).
The AMT grants an exemption that is phased out at higher income levels and imposes the AMT rates at specified income thresholds:
2019 AMT Rates Single Married filing jointly 26% Up to $194,800 Up to $194,800 28% $194,800+ $194,800+ Exemption amount $71,700 $111,700 Exemption phase-out $510,300 $1,020,600
Passive property loss limitations
Generally, losses (the excess of deductions over gross income) from a passive trade or business activity in which you do not materially participate are disallowed when calculating your taxable income for a tax year. However, if you or your spouse actively participated in a passive rental real estate activity (of real estate located within or outside of the United States), you can deduct up to $25,000 (or $12,500 if married filing separately) of losses from that activity from your non-passive income. “Active participation” includes making management decisions such as approving new tenants, deciding on rental terms, and approving expenditure. This allowance is reduced by 50% of the amount of your modified adjusted gross income that exceeds $100,000 (or $50,000 if married filing separately), and reduced to nil if your modified adjusted gross income is $150,000 ($75,000 if you’re married filing separately) or more.
Foreign currency gains on repayment of debt
Foreign currency gains or losses can arise due to the changes in exchange rates between the dates when foreign currency or assets denominated in non-functional (i.e. non-US dollar foreign currency) are acquired and disposed.
The IRS does not consider Bitcoin and other types of virtual currencies are not non-functional currencies for the purposes of these rules (see IRS Notice 2014-21).
Under Internal Revenue Code section 988, such gains or losses are generally characterized as ordinary income and are determined separately from the underlying transactions giving rise to them.
Such transactions include:
- acquiring a debt instrument or becoming a debtor (“obligor”) under such instrument;
- accruing expenses or gross income or receipts payable or receivable after the accrual date
- acquiring financial instruments such as forward contracts, futures contracts, and options contracts – however, taxpayers can elect to characterize the exchange gain or loss as capital gains or losses if the underlying contract is on capital account, and is not part of a straddle or a regulated futures contract or non-equity option for which the taxpayer has elected to have treated on income account); and
- disposing of foreign currency.
Currency gains on sale of foreign real estate
If a U.S. taxpayer executes a transaction in a foreign currency denomination, that amount must be translated into the U.S. dollars (at the applicable exchange rate) on the date of acquisition.
Foreign currency exchange gains from the sale of foreign real estate can arise from the foreign exchange rate conversion into US dollars of the mortgage debt on the mortgage entry date and the mortgage repayment date. A foreign currency exchange loss is non-deductible as the mortgage was not entered into in a trade or business or with a motive to make a profit. A corresponding gain is however taxable as ordinary income and may not be offset against losses on the sale of the property.
Are you head of household, married filing jointly, and what does that mean?
When filing taxes in the U.S. your tax filing status can affect the amount of taxes you pay for that year. Your marital status at the end of the tax year (December 31) will determine your tax filing status for that year.
There are 5 filing statuses:
- Single. If you are not married, or are divorced or legally separated under State law, you may file as “Single”.
- Married Filing Jointly. If you are married as at December 31 (or if your spouse died during the tax year), and if you and your spouse both agree to file a joint tax return, you may do so, reporting your combined income and allowable deductions. A joint return may be filed even if one spouse had no income or deductions. By filing jointly, your combined tax liability may be lower than if you filed separately as your standard deduction (if you choose to not itemize deductions) may be higher.
- Married Filing Separately. You and your spouse may choose to file separate tax returns, if doing so results in you paying less tax than when filing a joint tax return, or if you prefer to be responsible for your own taxes.
- Head of Household. You may file as head of household if you are not married, have paid more than half the upkeep on a home for yourself and a “qualifying person”, such as a dependent child who lives with you for more than half the year. A dependent parent may also be a “qualifying person” even if they do not live with you. The benefits of filing under this status is that your tax rate will generally be lower and you will receive a higher standard deduction (than if you file as single or married filing separately).
- Qualifying Widow(er) with Dependent Child. This status may apply if your spouse died in the preceding 2 years and you have a dependent child.
Sales of U.S. real estate by residents and non-residents
If you are a non-resident alien, a disposition of U.S. real estate is subject to income tax withholding under the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), as follows:
- Withholding tax = Amount realized on the disposition of the real estate x 15%
- Where the amount realized is calculated as: Sale price + fair market value of other property transferred – Liabilities assumed by the Transferee / Purchaser
Tax Equalization and Tax Protection. What is each and how does it impact you?
Tax Equalization refers to the process of ensuring that U.S. expats working for global businesses pay the same amount of tax when working abroad, as they would working in the U.S.
To achieve this, the employer calculates the total tax that the employee would pay in the U.S, and then withholds this amount (referred to as the “Hypothetical Tax”) from the employee’s salary, remitting it to the foreign and U.S. State taxing authorities and the IRS.
In such cases, due to the differences in tax rates between countries, an employee would benefit when working in a country with higher taxes than the U.S., whereas the employer benefits if the employee works in a country with lower taxes than the U.S.
Tax protection achieves the same objective, but places the home and host country tax compliance burden on the employee – so that employee is responsible for paying all (domestic and foreign) taxes. At the end of each tax year the taxes are reviewed, and if actual taxes paid exceeds the Hypothetical Tax amount, the employer reimburses the employee.
Subject to certain exceptions, under section 1445 of the IRC, the transferee / purchaser is obliged to determine if the transferor is a “foreign person” and then withhold the applicable amount, or risk being liable for payment of the tax.
If you are a U.S. citizen or resident alien, a gain on the sale of real estate held in the U.S. in your own name, would be taxed at the long-term capital gains rate of 15%, if the property was held by you for more than a year. Further, if the property was used as your principal residence, a gain of up to $250,000 ($500,000 if married filing jointly) may be excluded on the sale. (Principal residence exclusion)