US tax pitfalls for a US person living abroad

 lists and describes the major investing difficulties faced by US persons living outside the US. US persons are US citizens and US permanent residents (also known as green card holders). Even if their physical green card has expired, US permanent residents remain fully taxable by the US until their permanent resident status is officially abandoned or rescinded.

The US is unique among developed nations in applying its full tax code both extraterritorially and permanently to US persons who do not live in the US. This creates significant investing problems, expenses, barriers, obstructions, and increased tax burdens for these individuals.

The information in this page describes the situation for current US citizens and green card holders. It also acts as a list of considerations and planning points for people who are not yet US citizens but are contemplating becoming one in future, and who do not plan to live in the US for the rest of their lives, and for US citizens living abroad who do not plan to return to the US to live, and who are considering renouncing their US citizenship to simplify their financial lives.

Introduction
The US taxes citizens and green card holders who do not live in the US, but these people are also within the tax jurisdiction of the country in which they live. Unless they live in a country with no income tax, this means they are subject to at least two overlapping tax regimes. And potentially more that two, where local and state taxes also apply.

The Foreign Earned Income Exclusion (FEIE) and Foreign Tax Credit (FTC) mitigate some of the most obvious cases where double-tax could occur, and there is a commonly held belief that together these eliminate US tax for US persons living abroad.

However, the FEIE and the FTC are both limited and inadequate, and they do not fully protect from double-tax or from US tax except in the simplest of circumstances. The FEIE is limited to only earned income, and while unused foreign tax credits can be carried over in years when they are not used, the requirement for them to be characterised may mean that excess credits in one category cannot be used to offset tax from income that is in a different category.

The sections below describe cases where you will, as a US person living abroad, face double-tax or added US tax on top of your local tax liabilities, and where there is no protection from the FEIE, FTC, or any tax treaties.

Earnings and salary
Specifically for employment earnings, as a US person living abroad, you can shelter up to a limited amount each year from US tax using the FEIE. Beyond this level though, you have to rely on foreign tax credits to mitigate US tax on foreign earnings.

Because of the stacking rule, the FEIE is less valuable than other deductions and exclusions. This rule requires you to calculate tax so that income above the FEIE is taxed as if no exclusion applied. In other words, it pushes income above the FEIE into higher tax brackets. It is therefore just a credit for the US tax that would have been due on the foreign income.

In addition, note that you must have a tax home in a country other than the US, and that the US does not recognise certain locations as foreign (for example, Antarctica). The FEIE can only be claimed on a timely filed tax return.

Alongside the FEIE, you may be able to obtain some extra protection from US tax on a foreign salary using the Foreign Housing Exclusion.

Where you earn above the FEIE, a foreign tax credit only helps if there is any local tax for you to credit against US tax. If you work in a country with low or no income taxes, you will have no foreign taxes available for credit. In this case, you will pay tax to the US, and your own overall tax bill will be higher than non-US citizens who are otherwise in the same position as you.

Investment income, dividends and interest
You are liable to US tax on interest, dividends, rent, royalties, and any other type of passive income that you receive as a US person abroad, no matter where that passive income is sourced. You can use foreign tax credits to reduce this US tax, but this will be no benefit where your local tax liability on this income is zero.

Some countries have no income taxes at all. And of those that do, some do not tax investment income. Or if they do, they tax it more lightly than other types of income, perhaps relying on sales taxes rather than income taxes for their tax revenue.

Where your US tax liability on passive income exceeds any local tax liability on the same income, you are left with a US tax bill to pay. You cannot claim a foreign tax credit for non-US sales taxes.

Locally tax-free savings and investment accounts
A common case where US persons living abroad can face tax liabilities in excess of those payable by citizens of other countries is where your country of residence generally taxes investment income, but offers limited tax-free or tax-advantaged local savings accounts and investment wrapper accounts.

Examples include UK Individual Savings Accounts (ISA) and Canadian Tax-Free Savings Accounts (TFSA). For both of these, all capital gains, dividends and interest occurring inside the wrapper are locally tax free. However, the US does not recognise these wrappers as a tax shelter, and so will tax all of the income occurring inside them annually, as if they were normal unwrapped savings or investment accounts.

The result is that you will again pay higher tax than any non-US citizen in comparable circumstances.

Net investment income tax
The Net Investment Income Tax (NIIT) is a tax surcharge of 3.8% on investment income, and is triggered if your total gross income exceeds certain levels. The IRS has explicitly disallowed applying foreign tax credits to reduce the NIIT. As a result, if subject to the NIIT you are likely to face double-tax.

If this investment income is not local-source, it is possible that your residence country may allow a tax credit for US NIIT paid. Otherwise, the result is pure double-tax on this portion of your investment income.

Capital gains
Capital gains give rise to several of the most vexing US tax problems for US citizens living abroad. Many countries either do not tax capital gains at all, or if they do then it is either lightly or with a sizeable exemption.

In contrast, the US fully taxes capital gains, and also differentiates between short-term and long-term holdings, so that short-term gains are treated as income and taxed more heavily. It also computes the capital gain for foreign assets based on the exchange rates in effect at the dates of purchase and of sale.

As a result of mismatches between the way the US and many other countries tax capital gains, it is easy for a US person living abroad to find themselves with a US capital gains tax liability that cannot be reduced or offset by any local tax liability.

Phantom currency gains
The US requires you to compute capital gains on foreign assets in USD only, using the exchange rate in effect when the asset was bought to arrive at the basis, and the rate in effect when the asset was sold to give the sale proceeds. This can result in a taxable USD gain, even where there is no local currency gain. And worse, the US taxes foreign currency gains at income tax rates.

For example, suppose you buy a rental property for €200,000 when the exchange rate is €1 = $1, and sell it later for, again, €200,000, but when the exchange rate has become €1 = $1.25. In EUR, your local currency, you have no gain. However, because the EUR/USD exchange rate changed while you owned that asset, you have a USD gain of $50,000. And you now owe US income tax on that $50,000. Because you have no local gain and so no local tax liability, you cannot reduce this US tax liability using foreign tax credits.

In the examples above, you are in a worse tax position than a similarly situated non-US citizen.

Sale of primary residence
In most countries, any gains you make on selling your primary home are generally free of tax. However, the US limits tax-free gains on your primary residence to $250,000 ($500,000 if married filing jointly), and also requires you to have lived in the house for two of the past five years before allowing any capital gains tax exemption.

Where you sell your local home and fall outside of these US tax exclusions, you face a US tax liability for the gain on your home's value that again cannot be offset or mitigated by using foreign tax credits. This US tax liability erodes your ability to buy another property, relative to other non-US citizens.

Paying down a foreign loan or mortgage
If you have a non-US loan, repaying it may create a US taxable event. This is a particular issue where the loan is a mortgage. Even superficially entirely normal actions such as remortgaging, changing mortgage provider, and making capital repayments can all lead to a US tax liability.

The culprit is phantom currency gains, already mentioned above. US Tax & Financial Services provides an example:

This can leave you significantly worse off, relative to non-US citizens who take identical actions.

Non-US pensions
Pensions are another treacherous area for US citizens living abroad. Some countries' tax treaties with the US cover pensions, at least partly, so in these countries the results might be less bad than in others, but grey areas in the treaty mean that poor tax outcomes are still likely.

The default case, where a non-US pension is not covered by treaty, is for the US to treat it as an ordinary unwrapped investment account, or potentially as a non-US trust. This can lead directly to double-tax, where contributions and gains within the plan are subject to US tax annually, and withdrawals are subject to local tax when taken. Also, full compliance with US tax reporting rules may be impossible, because of lack of information from the pension scheme itself.

Even if you live in a country where there is a treaty covering pensions (and the US does not disallow the pension articles using its saving clause ), you may still face problems.

For example, the US/UK treaty covers some UK pensions reasonably well, particularly employer pensions, but it limits your contributions to only what you would have been able to contribute to a similar plan, a 401k or IRA say, if you were employed in the US. US annual retirement savings limits are generally lower than UK ones, so you cannot save as much for retirement as your non-US citizen peers and colleagues can. You must also watch out for the US highly compensated employee (HCE) rule, something that non-US citizens can of course ignore entirely.

The situation in Australia is particularly poor. Australian superannuation plans are partly compulsory, but are not covered by the US/Australia tax treaty. If you live in Australia, you may have to declare your superannuation plan as a foreign grantor trust, with extreme and onerous US tax and reporting outcomes. One expert explains:

Treaties may offer some protection, so in the best cases you will only be subject to additional rules and restrictions on local retirement savings plans. In the worst cases though, you will face double-tax on your retirement savings, once by the US and then later on by your home country.

Prizes, lottery and gambling winnings
In many countries, prizes and winnings are tax-free. The US however, treats all gambling winnings, prizes, lottery wins, and any other competition wins as taxable income. This would encompass everything, from winning €100 million in the EuroMillions lottery through to winning a cake at the local village fair.

So if you live in the UK and win £1 million in UK premium bonds, you might face paying close to $350,000 in US income tax on this prize, and with no foreign tax credit offset. In contrast, a non-US citizen would pay nothing.

Receipt of gifts and bequests
As a general rule, US persons do not need to report receipt of gifts and bequests to the IRS. However, there is an exception for receipts of gifts and bequests from non-US persons in excess of $100,000 in a year. These need to be reported on Form 3520, under threat of penalties of $10,000 for late filing or noncompliance.

Section 2801 tax on gift and bequest recipients
US persons do not pay tax on gifts or bequests received, but with one important exception. Gifts and bequests from a covered expatriate (under the US expatriation tax rules) are subject to a 40% transfer tax on receipt, payable by the recipient. The US introduced section 2801 tax in 2008, but as of 2019 the IRS has still not created a route to compliance with this law. This is an impressively long delay, even by the standards of the IRS.

When the IRS does finally get round to implementing section 2801 tax, if you receive a gift or bequest from a covered expatriate you will be much worse off that a non-US person receiving the same gift or bequest. Until then, this tax is officially deferred, meaning that you do not -- in fact, cannot -- pay it now, but you need to budget for it becoming collectable in future.

Controlled foreign corporations
If you are an officer, director, or substantial shareholder in a company registered in your home country, the US may treat that company as a controlled foreign corporation (CFC). This generates extremely onerous US tax reporting requirements, with penalties of up to $60,000 for noncompliance or late filing.

The Subpart F tax rule is particularly unpleasant. Buzzacott explains:

As the owner of a company that the US views as a CFC, you can face a much higher tax burden than a non-US citizen with the same level of ownership.

Partnerships with non-US persons
The controlled foreign corporation (CFC) rules outlined above can also make it difficult for you as a US citizen to enter into partnerships with other non-US citizens. Your participation will embroil the non-US corporation in a lot of US tax reporting that most non-US persons and companies are keen to avoid.

Anecdotally, US citizens are now finding it hard to enter into partnerships outside the US, and may find that they are being passed over for senior roles in existing companies.

Extensive and intrusive reporting requirements
As a US person living abroad, you will have to deal with many more, and complex, IRS forms. These are forms that people living in the US will rarely encounter, if ever. These forms are difficult and time-consuming to complete, and costly if you find that you are forced to used a paid preparer. They are also intrusive, since they require you to list not just your taxable and non-taxable income, but also the full details of all your non-US accounts -- income, account number, highest balance during the calendar year, name of non-US financial institution, and so on.

Typical forms you will encounter, above and beyond the normal form 1040 and all of its associated schedules and extra forms, are:
 * Form 2555, for claiming the Foreign Earned Income Exclusion.
 * Form 1116, to claim a Foreign Tax Credit. You might need to complete several of these.
 * Form 8938, Statement of Foreign Assets. Here you list the details, income and balances of all your non-US accounts. Essentially duplicative with FinCEN form 114, but often both must be filed.
 * Form 8833, Treaty-Based Return Position Disclosure. Used to claim tax treaty benefits.
 * Form 5471, Information Return of US Persons With Respect to Certain Foreign Corporation. Used for controlled foreign corporations (CFC).
 * Form 8865, Return of US Persons with Respect to Certain Foreign Partnerships. As above, just more of the same.
 * Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company (PFIC). Extremely time-consuming, but required if you hold any non-US domiciled funds or ETFs. The IRS's estimated time to complete this form is over 48 hours.
 * Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts. For any activity involving non-US trusts, and also for gifts and bequests from non-US sources above $100,000.
 * Form 3520A, Annual Information Return of Foreign Trust with a US Owner. Required if you own a local trust. Another extremely time-consuming and complex form.
 * FinCEN Form 114, Foreign Bank Account Reporting (FBAR). Filed annually with the Financial Crimes Enforcement Center. This form can only be filed electronically. The threshold for filing is very low, just $10,000 in non-US accounts. Essentially duplicative with form 8938, but often both must be filed.

Disadvantageous tax filing status options
If you are married, you have the choice of filing US tax as Married Filing Jointly (MFJ) or Married Filing Separately (MFS). If your spouse is not a US person though, choosing MFJ will subject them to the full extent of difficult and unpleasant US tax laws on all of their own non-US income and financial affairs.

Most non-US spouses (sensibly) wish to keep the IRS entirely out of their personal financial affairs. This means that unless you can use Head of Household status, you will be obliged to use MFS when you file your US taxes. This is generally less advantageous than filing jointly with a spouse, and often also less advantageous than filing Single. In other words, you are pushed into the US tax filing category that has the highest tax rates and the lowest allowances of all the available options.

This usually has the effect of leaving you in a worse tax position than a similarly situated US citizen living in the US.

Expensive tax filings
Unless your finances are extremely simple, using a paid preparer to complete your US tax return will be extremely costly. Typical fees to complete forms such as 3520 and 5471 alone run to between $200 to $600 for each copy needed, in addition to the base cost of completing the 1040 and its associated schedules.

US expats with finances that are entirely regular and vanilla in local terms regularly complain of US tax preparation fees in excess of $2,000 to $3,000 annually. This is an out-of-pocket expense that your non-US citizen peers do not have to pay.

Extreme penalties for noncompliance
The penalties for noncompliance of US reporting rules are draconian, often two orders of magnitude or more above the penalty that would be imposed on a US resident for similar noncompliance or late form filing.

For example, the penalty for a late-filed form 3520 begins at $10,000. Moreover, the IRS has begun aggressively enforcing this penalty. The penalty for non-filing of form 8938 starts at $10,000 and rises to $60,000. And the penalty for non-filing of form 8865 follows the same pattern.

The most extreme penalty of all -- and one that may arguably be in violation of the US constitution's eighth amendment excessive fines clause -- is the civil penalty for not filing form FinCEN 114 (also known as FBAR). This is $12,921 if non-wilful, and the higher of $129,210 or 50% of the highest account balance for the year, if wilful. Penalties may apply per year, in the case of multiple year violations, so that in the worst cases the penalties for non-filing may exceed the account balance.

As a US person residing abroad, you have to learn to live with the perpetual risk of these oppressive penalties for simple form errors. Many US expats find that this alone creates considerable emotional and mental stress, quite apart from the bureaucratic nuisance and tax expense of the US's citizenship-based taxation regime.

FATCA, PRIIPs and PFIC
One of the effects of the Foreign Account Tax Compliance Act (FATCA) is that non-US banks and financial institutions are now forced to search their customer bases for 'US indicia' such as a US phone number, US address, or US place of birth, and then report any customers that they suspect of being US persons either to the IRS directly, or indirectly through their own country's tax authority where that country has signed a FATCA Intergovernmental Agreement (IGA) with the US. The threat from the US for noncompliance is a withholding tax of 30% on all payments from the US to that non-US bank or financial institution.

Because this is both a major costly administrative burden and a significant compliance penalty risk, a number of non-US banks and financial institutions have taken the commercial decision to no longer offer services to US persons. This includes those living in the same country as the bank, and who may also be full citizens of that country as well as being US citizens. As further fallout, some US financial institutions now also refuse service to US persons who are not living in the US.

In 2018, an EU regulation known as PRIIPs became operational. It requires funds and ETFs sold to EU residents to provide a Key Investor Information Document (KID, or KIID) in a particular format. As of 2019, no US domiciled fund or ETF produces a KID.

And a US tax law, Passive foreign investment company (PFIC), applies unpalatable tax rules to US persons who own non-US domiciled funds or ETFs.

These three rules combine in a way that can make it functionally impossible for you to own any index funds or ETFs. The only viable route is through a US based account with US based broker. Opening one may involve convincing them that you are a US resident, even though not. Otherwise, you run into problems opening a local brokerage account due to FATCA. And if you can find and open one, you will not be able to buy US domiciled funds or ETFs, and will run into the US PFIC tax rules if you use non-US domiciled ones.

Your non-US citizen peers, friends, and family can invest freely through local brokerages, using non-US domiciled index funds and ETFs, without any of these tax drawbacks and limitations.

Reed amendment
Potentially banned from entering the US in future

Retroactive US tax laws
GILTI, expatriation tax

Entangling children in US tax laws
For example, baby Archie Mountbatten-Windsor.