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There are many reasons for you to have foreign income, you may be living and working abroad, or studying, you may have gains from investments or other sources of foreign income. As long as you are a U.S. citizen or resident alien, you must report income from all sources within and outside of the U.S. This is true whether or not you receive the familiar W-2 or 1099 or any of the foreign equivalents.
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Of course, since reporting income means paying taxes and having to deal with the IRS, there are numerous and extensive rules and regulations on what kind of income is taxed and how much, on exclusions, credits and deductions.
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First of all, here is the special classification the IRS has come up with for different types of foreign income.
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Earned Income, which is defined as pay for personal services performed includes salaries and wages, commissions, bonuses, professional fees, tips.
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a.
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Noncash Income is also earned income and includes the fair market value of property or facilities provided to you by your employer in the form of lodging, meals, or use of a car;
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| b. |
Also included are amounts paid to you as allowances or reimbursements for the cost of living, education, home leave, moving expenses.
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- Unearned Income refers to dividends, interests, capital gains, gambling winnings, pensions, annuities, alimony, and social security benefits.
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- Variable Income refers to business profits, royalties and rents.
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| Some types of income (such as income from sole proprietorships, partnerships, and corporations, stock options, pensions and annuities, royalties, rents, and fringe benefits) are not easily identified as earned or unearned income so they have their very own chapter in the Tax Guide for U.S. Citizens and Residents Aliens Abroad. |
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Foreign earned income is income you receive for performing personal services in a foreign country no matter where and how you are paid.
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If you meet certain requirements, you may qualify for the foreign earned income and foreign housing exclusions and the foreign housing deduction. These requirements are that:
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- You must have foreign earned income,
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- Your tax home must be in a foreign country, and
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- You are one of the following:
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| a. |
A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year,
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A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, or
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| c. |
A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.
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| If you qualify, you are entitled to exclude from your taxable income a certain amount of your foreign earnings that is adjusted annually for inflation. For 2014 the amount to be excluded is up to $99,200, and for 2015 it is up to $100,800. In addition, you can exclude or deduct certain foreign housing amounts. |
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| The foreign earned income exclusion is voluntary; you can claim it by completing Form 2555 or Form 2555-EZ together with a timely filed return or a late-filed return filed within 1 year from the original due date of the return (determined without regard to any extensions). |
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| You may also be entitled to a foreign tax credit or deduction. |
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The foreign tax credit allows you to reduce the double tax burden that would otherwise arise when foreign source income is taxed by both the United States and the foreign country from which the income is derived.
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Generally, only income taxes paid or accrued to a foreign country or a U.S. possession, or taxes paid or accrued to a foreign country or U.S. possession in lieu of an income tax, qualify for the foreign tax credit.
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| The tax must meet four tests to qualify for the credit: it must be a legal and actual foreign tax liability; the tax must be imposed on you; you must have paid or accrued the tax, and it must be an income tax (or a tax in lieu of an income tax). |
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| You can choose to take the amount of any qualified foreign taxes paid during the year as a foreign tax credit or as an itemized deduction. To choose the deduction, you must itemize deductions on Schedule A. To choose the foreign tax credit you generally must complete Form 1116. |
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You may not take either a credit or a deduction for taxes paid or accrued on income you exclude under the foreign earned income exclusion or the foreign housing exclusion.
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| There is no double taxation in this situation because that income is not subject to United States tax. However, you can choose to take the foreign tax credit on any amount of foreign income which has not been excluded under the foreign earned income exclusion or the foreign housing exclusion. |
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| If you are living abroad on April 15, you may qualify for an automatic two-month extension to file your federal income tax returns, just like those serving in the military outside the U.S. You must attach a statement to your return explaining why you qualify for the extension. |
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| If you are a U.S. citizen with investment (or unearned) income from sources outside the United States, you must report that income on your tax return unless it is exempt by U.S. law. This is true whether you reside inside or outside the United States and whether or not you receive a Form 1099 from the foreign payer. |
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| If you pay taxes on your investment income in the country of origin, you have the same chance of avoiding the double taxation by claiming either the Foreign Tax Credit or a deduction (if you itemize) on your tax return. |
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The Form 1099-DIV or 1099-INT payee statement that you should receive at the end of the year will show in Box 6 how much of your earnings were withheld by a foreign government. If the tax you paid to the foreign government is higher than your U.S. tax liability, then the maximum foreign tax credit you can claim will be the U.S. tax due, which is the lesser amount. If the tax you paid to the foreign government is lower than your tax liability in the U.S., you can claim the entire amount as your Foreign Tax Credit.
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If you receive foreign sourced qualified dividends and/or capital gains (including long-term capital gains, unrecaptured section 1250 gain, and/or section 1231 gains) that are taxed in the U.S. at a reduced tax rate, then you must adjust the foreign source income that is reported on Form 1116, line 1a. Otherwise, the allowable foreign tax credit may be significantly overstated which can trigger a substantial underpayment penalty.
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You may need to file Schedule B, Interest and Ordinary Dividends, with your U.S. tax return. You may also need to file Form 8938, Statement of Specified Foreign Financial Assets.
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| Instructions for Form 8938 explain the thresholds for reporting, what constitutes a specified foreign financial asset, how to determine the total value of relevant assets, what assets are exempted, and what information must be provided. |
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| It is also worth mentioning that if you have a financial interest in or signature authority over a foreign financial account, including a bank account, brokerage account, mutual fund, trust, or other type of foreign financial account, exceeding $10,000 at any time during the calendar year reported, you are required to report the account yearly to the Department of Treasury by electronically filing a Financial Crimes Enforcement Network (FinCEN) 114, Report of Foreign Bank and Financial Accounts (FBAR). If you hold a foreign financial account, you may have a reporting obligation even when the account produces no taxable income. |
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| All these pieces of information are merely painting an overall landscape of the complicated and ever growing number of rules and exceptions to the rules that accompany any and all codes of the federal tax laws. To make sure you take advantage of every tax deduction, credit, or exclusion you are entitled to, please get help from a tax professional. |
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