U.S. Tax Residents: How to Avoid Double Taxation?
U.S. tax residents are required to report income from all over the world. “But that’s double taxation,” you might say. “I’ve already paid tax on that income in another country.”
There are two main ways to avoid double taxation of income:
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Foreign Earned Income Exclusion using Form 2555. Earned income is considered to be wages, self-employment income, commissions, etc. Unearned income is interest or capital gains.
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Claiming a Foreign Tax Credit using Form 1116. The credit can be used for any type of income.
Foreign Earned Income Exclusion (FEIE)
This allows you to exclude up to $130,000 of income and applies in two cases:
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You are absent from the U.S. for more than 330 days.
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Your “tax home” is in another country where your business or employment is located. This is the place where you maintain your regular place of abode (i.e., the place where you regularly live). Remember: if your “home” address is abroad, it does not automatically mean it is your tax home. It all depends on where you maintain your family, economic, and personal ties. Did you open a foreign bank account? Did you get a foreign driver’s license? These are just a few of the questions used to determine whether you have established your foreign tax home outside the U.S.
Foreign Tax Credit (FTC)
This is applicable to both earned and investment income. To claim this credit, you must have paid foreign income tax on your foreign income in another country. Note that this must be the equivalent of the U.S. federal income tax. Foreign taxes such as property taxes, social security taxes, or value-added taxes (VAT) do not count.
The Foreign Tax Credit can fully or partially reduce your U.S. tax liability. A reminder that this is a non-refundable tax credit. Unused credit can be carried forward for 10 years.
