Your US Tax Liability
How your US tax liability is offset when you live abroad
Many US taxpayers incorrectly believe that they are not required to file a US tax return if they live abroad and earn less than around $100,000. This is a common misconception that stems from confusion around the Foreign Earned Income Exclusion (FEIE). The FEIE, together with the system of Foreign Tax Credits (FTCs), are the two main ways that US taxpayers abroad reduce their US tax liability so that they are not "double taxed". Note that generally neither of these can be used to reduce tax owed on any US-sourced income earned when living abroad.
The Foreign Earned Income Exclusion
The FEIE on Form 2555 is used to reduce the amount of income on your US tax return that is subject to tax when living abroad. In 2022, taxpayers whose "tax home" is in a foreign country and who pass one of two eligibility tests can reduce their foreign earnings by up to $112,000 using the FEIE. These tests are the Bona Fide Residence Test and the Physical Presence Test:
If you pass either of these tests, your total income is reduced by up to $112,000 (or your total foreign earned income, if less) and as a result you avoid paying US tax on your foreign earnings. Note that this can only be used to reduce your earned income- non-earned sources of income such as interest, dividends, capital gains, gambling winnings etc. cannot be excluded by the FEIE.
On Form 2555 you can also take an exclusion (if employed) or deduction (if self-employed) for certain foreign housing expenses that exceed the base housing amount (equal to 16% of the FEIE). In practice, you will generally only be able to utilize this if you are paying rent (if you are paying a mortgage, you can deduct the interest in your itemized deductions). There is also a maximum limit on excludable/deductible expenses, depending on which city you are living in; in London, this limit is $69,500 for 2022.
Foreign Tax Credits
If your foreign income is above the FEIE amount, or if you have non-earned foreign-sourced income, you can still offset the US tax liability on this income by utilizing foreign tax credits (FTCs) for taxes paid to a foreign government by filing Form 1116. Certain taxpayers may choose to claim a credit for foreign taxes accrued in the year instead of those paid in the year (although most foreign taxpayers stick to the cash basis).
FTCs are applied on Form 1040 after your total US tax liability has been calculated. Form 1116 must be used to calculate the maximum allowable credit that you can carry to your Form 1040, which is limited to the amount of tax that you owe on the proportion of your income that is foreign-sourced; in other words, the IRS does not allow you to use the foreign taxes you have paid to offset the tax on your US-sourced income.
Since foreign income taxes are often higher than federal US taxes, many US taxpayers living overseas will have enough foreign tax credits to offset the entire tax liability on their foreign income. The excess, unused credits can be carried forward to offset future US tax liabilities on your foreign income for up to ten years. As a result, US taxpayers living in the UK who pay UK tax on their income are very unlikely to owe tax to Uncle Sam except on their US-source income, since UK income taxes are generally higher than the US taxes that would be due on the same income.
However, there are different "baskets" of credits that must be used to offset the tax on different types of income. The most common baskets are the "passive" and "general" baskets. Passive basket credits essentially apply to unearned income (interest, dividends etc.) while general basket credits generally apply to earned income such as wages. This means that credits that you receive for taxes paid on your wage income, for example, cannot be used to reduce the US tax that you may owe on your foreign-sourced capital gains, interest, etc.
Many US taxpayers incorrectly believe that they are not required to file a US tax return if they live abroad and earn less than around $100,000. This is a common misconception that stems from confusion around the Foreign Earned Income Exclusion (FEIE). The FEIE, together with the system of Foreign Tax Credits (FTCs), are the two main ways that US taxpayers abroad reduce their US tax liability so that they are not "double taxed". Note that generally neither of these can be used to reduce tax owed on any US-sourced income earned when living abroad.
The Foreign Earned Income Exclusion
The FEIE on Form 2555 is used to reduce the amount of income on your US tax return that is subject to tax when living abroad. In 2022, taxpayers whose "tax home" is in a foreign country and who pass one of two eligibility tests can reduce their foreign earnings by up to $112,000 using the FEIE. These tests are the Bona Fide Residence Test and the Physical Presence Test:
- Bona fide residence: You are a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
- Physical presence: You are physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.
If you pass either of these tests, your total income is reduced by up to $112,000 (or your total foreign earned income, if less) and as a result you avoid paying US tax on your foreign earnings. Note that this can only be used to reduce your earned income- non-earned sources of income such as interest, dividends, capital gains, gambling winnings etc. cannot be excluded by the FEIE.
On Form 2555 you can also take an exclusion (if employed) or deduction (if self-employed) for certain foreign housing expenses that exceed the base housing amount (equal to 16% of the FEIE). In practice, you will generally only be able to utilize this if you are paying rent (if you are paying a mortgage, you can deduct the interest in your itemized deductions). There is also a maximum limit on excludable/deductible expenses, depending on which city you are living in; in London, this limit is $69,500 for 2022.
Foreign Tax Credits
If your foreign income is above the FEIE amount, or if you have non-earned foreign-sourced income, you can still offset the US tax liability on this income by utilizing foreign tax credits (FTCs) for taxes paid to a foreign government by filing Form 1116. Certain taxpayers may choose to claim a credit for foreign taxes accrued in the year instead of those paid in the year (although most foreign taxpayers stick to the cash basis).
FTCs are applied on Form 1040 after your total US tax liability has been calculated. Form 1116 must be used to calculate the maximum allowable credit that you can carry to your Form 1040, which is limited to the amount of tax that you owe on the proportion of your income that is foreign-sourced; in other words, the IRS does not allow you to use the foreign taxes you have paid to offset the tax on your US-sourced income.
Since foreign income taxes are often higher than federal US taxes, many US taxpayers living overseas will have enough foreign tax credits to offset the entire tax liability on their foreign income. The excess, unused credits can be carried forward to offset future US tax liabilities on your foreign income for up to ten years. As a result, US taxpayers living in the UK who pay UK tax on their income are very unlikely to owe tax to Uncle Sam except on their US-source income, since UK income taxes are generally higher than the US taxes that would be due on the same income.
However, there are different "baskets" of credits that must be used to offset the tax on different types of income. The most common baskets are the "passive" and "general" baskets. Passive basket credits essentially apply to unearned income (interest, dividends etc.) while general basket credits generally apply to earned income such as wages. This means that credits that you receive for taxes paid on your wage income, for example, cannot be used to reduce the US tax that you may owe on your foreign-sourced capital gains, interest, etc.
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