The life of a digital nomad is full of challenges, and taxes often top the list of travelers’ main concerns. On its own, the US tax code is extraordinarily complex, and if you also have to consider the tax laws of one or more foreign states, tax compliance can quickly become the most difficult parts of living a nomadic lifestyle.
While we cannot cover every aspect of foreign tax compliance in a single article, we can discuss some of the hottest topics. Today, we want to go over two techniques you could employ to reduce your US tax bill if you find yourself owing taxes to one or more foreign countries.
Foreign Earned Income Exclusion (FEIE)
The Foreign Earned Income Exclusion (FEIE) is often the first line of defense for US taxpayers who earn income abroad and wish to reduce their tax burden here at home. For those who qualify, the FEIE allows you to exclude up to $112,000 (in 2022) of foreign earnings from US federal income tax. Married taxpayers who both qualify for the FEIE can exclude up to $224,000 of foreign earnings.
To qualify for the FEIE, your tax home must be in one or more foreign countries, and you must pass either the bona fide residence test or the physical presence test.
Tax Home in a Foreign Country
Your tax home is where you maintain a place of business or are permanently or indefinitely engaged to work. If you travel nomadically, your tax home is wherever you work, which means that you may have multiple tax homes during a single tax year.
Bona Fide Residence and Physical Presence Tests
If you are a US citizen, you must pass one of these tests to be eligible for the FEIE.
To pass the bona fide residence test, you must reside in one or more foreign countries for an uninterrupted period that includes an entire tax year. You can briefly return to the US to visit, but you must intend to return to your foreign tax home when your visit is complete.
If you can’t pass the bona fide residence test, you may still claim the FEIE if you pass the physical presence test. To pass this test, you must reside in a foreign country for at least 330 full days during any 12-month period. This 330-day period does not include travel days or time spent in or over international waters (like on a cruise ship or on an intercontinental flight). The physical presence test is often easier for nomadic travelers to qualify for because the IRS doesn’t care why you are traveling internationally or for how long you plan to be away from the US. As long as you pass that 330-day threshold, you’re in the clear.
If you are a US resident alien, there are slightly different rules for you to qualify for the exclusion. Reach out to us if you fall into that category.
How do I calculate the FEIE?
When calculating the exclusion, you need to first determine which of your income is foreign earned. Foreign-earned income includes wages, salaries, bonuses, commissions, professional fees, and self-employment income paid to you while you were living in a foreign country. It does not include payments for military service or unearned income like interest, dividends, and Social Security.
File IRS Form 2555 with your annual tax return to claim the FEIE.
Foreign Tax Credit (FTC)
Taxpayers who are ineligible for the FEIE often rely on the FTC to reduce their US tax bill for foreign taxes.
The FTC is a dollar-for-dollar credit you can claim on your US tax return for taxes paid to a foreign country or a US possession (which includes Puerto Rico, US Virgin Islands, Guam, the Northern Mariana Islands, and American Samoa). The FTC has a few limitations.
You must have paid or accrued the tax.
If you’ve paid or accrued the tax yourself, the FTC is fairly simple to calculate. It gets a bit trickier when foreign taxes are paid or accrued on your behalf, like by a partnership, S corporation, or trust.
You cannot claim an FTC that’s related to income you’ve excluded or income you’ve used to calculate an itemized deduction.
The most common example of this limitation is the FEIE. You cannot take an FTC that’s related to income you’ve excluded under the FEIE. You may be able to claim both the FEIE and the FTC, but you cannot “double dip” by using the same foreign earnings to qualify for both.
The foreign taxes must be income taxes.
The only taxes that qualify for the credit are war profits, excess profit taxes, income taxes, and taxes in lieu of income taxes. Click here to see a complete list of what types of taxes are ineligible for the FTC.
How do I calculate the FTC?
There are two ways you can take the FTC: as a deduction or as a credit.
To take the deduction, report foreign taxes on Schedule A of your Form 1040. If you itemize your deductions (rather than taking the standard deduction), this will lower your US taxable income.
To take the credit, file Form 1116. The calculations can be a bit onerous, but in general, you’ll divide your foreign-source income by your taxable income from both US and foreign sources, then multiply the result by your US tax liability.
Most taxpayers are better off taking the credit because a dollar-for-dollar reduction in your tax bill will almost always beat out a reduction in your taxable income, but talk to an advisor to be sure.
Which is Better: The FEIE or the FTC?
Each year you can choose whether you want to take the FEIE or the FTC. Here are a few questions you should ask yourself to help you make the decision:
Do I even qualify for the FEIE?
If you can’t meet either the bona fide residence test or the physical presence test under the FEIE, your only option is to take the FTC.
What type of income do you have?
If you have earned foreign income (like wages or self-employment earnings), you can take either the FEIE or the FTC. If you have only unearned foreign income (like dividends and interest), the FTC is your only option.
What are the tax rates?
If the foreign country’s income tax rate is lower than the US tax rate, you may see more of a benefit from taking the FEIE. If the foreign country’s tax rate is higher, the FTC may be better.
Traveling full time can be an exciting new adventure, but digital nomads need to think about taxes a bit differently than most other taxpayers. We have a wealth of information for digital nomads here, but please reach out to us at AB FinWright if you’d like to talk to us about your specific needs. We have years of experience working with international travelers and feel confident we can get your taxes to where they need to be.