Generally speaking, if you’re a citizen of the good ol’ U.S. of A. and make anything anywhere above the filing threshold (earned income AND everything else!) no matter where you are, you’re legally obligated to file. In fact, the U.S. is one of the very few countries that operates a citizenship-based tax system rather than a residency-based system. Yep, the vast majority of nations on this planet take a common sense approach to tax collection — you pay taxes on your earned income to the country where you have your tax residency. Makes sense, right? If there’s one thing I’ve learned over the years, it’s that common sense and U.S. tax code go together about as well as oil and water.
Obligatory Cover-My-Butt Statement
Now, before we go any further, I’d like to stress the fact that I am not in any way, shape, or form a tax professional. I’m just a dude pounding on his laptop in a hammock, sharing our experience as tax-paying U.S. citizens working and living overseas. Take from this what you will, but take it all with a grain of salt.
It doesn’t surprise me in the least that I frequently come across Americans overseas who just don’t bother to file. Sure, many don’t owe anything, but lots do and don’t even know it. Those who know for certain that they don’t owe any taxes don’t file because the code is too complex or it’s just too much of a pain in the butt. And why would someone who doesn’t owe taxes want to pay hundreds of dollars to hire a professional to walk them through it?
Well, for one, the penalties are insane if the IRS does catch you.
(And that’s Internal Revenue Service, i.e. the “Tax Man” for my non-American friends reading this)
Never mind that in most cases the IRS is unable to track overseas income like they do in the States and virtually have no idea what any expat’s foreign earned income really is. Sure, they’re able to track Americans’ foreign bank accounts now via recently strengthened reporting requirements for foreign banks (via FATCA, etc.), but that’s really only if you carry a balance of $10,000 over over. Needless to say, that generally doesn’t apply to the average Joe-expat that we’ve met, and it certainly doesn’t apply to us.
Regardless, the law’s the law, and if you file and get audited (or laws change down the line making it harder not to file), life might well become one very large suckfest, very quickly.
Plus, sometimes the government owes YOU money, even if you have no tax liability for the current filing year. For example, this year, even though we had no tax obligation to the State of Oregon (location of our pre-Laos tax residence), I still filed a non-resident return to claim our $147 kicker refund resulting from paying into a 2016 tax surplus — just for taking a few minutes to file electronically (the app did most of the work on that one). No regrets there.
In our case, I guess it also helps that I love tax season.
Yep, you read that right.
Each year, for the better part of two decades, I anxiously await the receipt of all of my tax forms (once-upon-a-time, paper upon paper upon paper in my mailbox, but now ones and zeros beamed to my pocket electronically over land, air, and sea). With forms in hand, I put on some work music (Zappa, flamenco, trance/rave, whatever), brew up a strong cup of coffee with my beloved AeroPress, and get down to business.
Don’t get me wrong, it’s not that I enjoy paying taxes more than anyone else. I just really love process…and the challenge. And it keeps on getting more challenging every year! With our crazy lifestyle, no two tax years are the same. Then you throw in stuff like ACA (Obamacare), self-employment, part-time (or multi-) state residency, foreign earned income, investments, and itemized deductions and you have yourself a full-blown kegger.
The complexity is fascinating to me. Some years, it’s pretty lame — plug some info from a W-2 and some 1098s, push a button and receive my refund. Boooooring. Other years (like this year) it’s an intricate puzzle requiring hours of late night sleuthing and calculating (and cross-referencing multiple free online tax apps) to get everything rock solid — and rock solid is my aim. I’d like to say it’s because I’m an upstanding, law-abiding citizen, but it’s really just part of the game. If it’s not 100% right, I didn’t solve the puzzle. And the thing with taxes, no matter how complex the situation, there’s always a solution.
Filing Taxes with Foreign Earned Income Can Be Complicated
So what did I learn this year? Well, even though Lori and I owed no tax to the U.S. government for 2017, it was a bit more complicated properly conveying this to the IRS than I anticipated. Even with the latest tax software, you have to really understand the terms being used and how they apply to your specific situation — tax home, tax residency, bonafide residence, physical presence, non cash income, exclusion vs. exemption, non-resident, foreign travel — even the term ‘housing’ isn’t straightforward.
I even had to jump ship from my [once] beloved TaxAct software after getting 90% of the way finished with my federal return only to find that taking the Foreign Earned Income Exclusion required form 2555, which in turn required a $29.95 upgrade!
Sure, I could have paid the $30 bucks and been done with it. But I’ve never paid to file in my life and wasn’t going to start now.
Back in the day when most tax apps offered free federal filing but charged $15 for a state return, I’d file the federal online, then copy the info by hand over to the state return and mail it in. Thankfully, I didn’t have to go full snail mail on my taxes this time around (which would have been interesting from Laos). I simply went back to the IRS free-file comparison chart and found another app that would do the job for free. I’d used H&R block for years back in the 2000s, and they appeared to fit the bill, so boom. Done.
I’ll start here by saying that form 2555 is a heinous bloodsucking banshee child of Uncle Sam, and one could easily lose every ounce of sanity obsessing over every line item. It would almost seem, based on F2555, that the U.S. government considers EVERY trivial aspect of an expat’s life taxable.
Your boss covered your meatball and grizzle noodle soup?
A sickly kitten missing two paws and an ear was left on your doorstep?
Buddha himself reincarnated for an instant just to bring you a bright pink friendship bracelet?
Declare! That! Sh*t!
Fortunately, once I got a handle on the terminology and what was actually expected of the filer, it was more or less straightforward. Foreign housing is a really weird and complex area that I’m not even going to touch here, but fortunately our fair market housing costs are minimal enough to keep things simple (and yes, even though Lori’s employer pays our rent, it’s still considered earned income — so is her per diem, for that matter).
So, now to answer the big question on everyone’s mind:
How the heck did we get away with owing zero tax to the U.S. in 2017?
Lori and I have spent a combined many years outside of the U.S., but have never found ourselves in a position where we were earning income overseas that exceeded the filing threshold and deductions/credits, but where we didn’t have to pay taxes to the U.S.
(and just a little side note, employment overseas with the U.S. government (military, Foreign Service, Peace Corps, etc.) generally doesn’t count as foreign income).
There are two magic potions that can get the job done — the Foreign Tax Credit and the Foreign Earned Income Exclusion.
Essentially, if you earn income overseas and are obligated to pay taxes to a foreign government, you can invoke the Foreign Tax Credit, which can be the more beneficial option for high income earners.
The Foreign Earned Income Exclusion, however, is quite a bit more difficult to qualify for — but if you qualify for this gem, you stand to wipe out up to $102,100 per individual (2017) of your AGI (taxable gross income, minus deductions). For folks like us, that’s more than enough to wipe away our entire tax liability to the U.S.
So how did we qualify for said exclusion?
Well, it ain’t easy. For one, your tax residence (not to be confused with bona fide residence, which we’ll discuss later) has to be outside of the U.S. You’ll want to dig deeper into what that means if you think it applies to you, but in a nutshell, your tax residence is where you were working and living during the tax year in question. As you might expect, you also have to spend some significant time outside of the U.S.
There are two avenues by which you can qualify for the Foreign Earned Income Exclusion:
The Bona fide resident test or physical presence test.
To meet the bona fide resident test, you need to not only have been away from the U.S. for one full tax year, you also need to have resided in one particular foreign country (your tax residence) for an uninterrupted period that includes one full tax year. If that weren’t enough, this test takes into account an array of factors such as the taxpayer’s intentions, nature of stay, etc. In other words, you’ve got to be pretty darn committed to your bona fide residence, with little or no intent to return to the U.S. anytime soon.
Needless to say, like most American expats in our shoes, we did not meet this test.
Thankfully, with our circumstances, meeting the physical presence test was easy.
The main criteria for meeting this test is actually being in a foreign country (or countries — i.e. outside of the U.S.) for 330 days of a 12-month period that begins or ends with the tax year in question. Having visited the U.S. for 26 days in 2017 (the IRS only counts whole days) we qualified with nine days to spare.
This exclusion doesn’t give a rip about intention or whether you were working or even sightseeing in said countries, but only that you were in some other country that is most definitely not the U.S. for at least 330 full days of that 12-month period. Since our tax residence is here in Laos and we only spent 26 days in the U.S. in 2017, we’re entitled to the exclusion.
But here’s where things get interesting.
Even though we didn’t leave the U.S. in 2016 until mid-September, we actually could have taken the exclusion the previous filing year (2016) for Lori’s foreign earned income from September through December of 2016. I was indeed aware of this last year when I filed, but chose not to take the exclusion for reasons I’ll explain later.
But how could we have qualified for the exclusion last year if we had only been outside of the U.S. for a little over three months in 2016?
You remember what I said before about being physically present in a foreign country for 330 days of a 12-month period? Guess what? That 12-month period does not have to coincide with the tax year in question — only begin or end in that tax year! That means when calculating your physical presence overseas, you can actually include the full days up until the day you file. So, if we had arrived in Laos on or before May 19th, 2016 and filed April 15th, 2017, without returning to the U.S., we would have qualified for the exclusion.
Hmm, but we didn’t arrive until September…
Here, it might be helpful to note that the filing deadline for U.S. persons living abroad is NOT in mid-April, but automatically extended to mid-June in most cases.
Great! But that doesn’t get us to September!
Well, what if I told you that you can actually request an ADDITIONAL extension… …to October 15th…
As you’ll remember, we left the U.S. September 17, 2016 and went back for 26 full days in July and August. So, if I wanted to, I could have filed my taxes in mid-September of 2017 (provided I was granted the additional extension, which is usually the case in these circumstances).
So why didn’t I?
Well, for one, the taxes owed on the three months of foreign income was quite small and not really worth waiting six months (I generally file in February). Also, Noe was born in 2016, and we were due a sizable refund. Our refund was earmarked to go directly to pay off the remainder of Noe’s hospital bill which was due in July. Plus, we’d be playing with fire to an extent with the October extension, given that if Lori had to return to the U.S. for any number of days beyond the max allowed (medical emergency, wedding, etc.) we’d all of a sudden find ourselves disqualified from the exclusion and owing taxes on the income. Given that the October extension only extends the filing date (and NOT the payment due date), we’d also incur a late payment penalty.
What about Obamacare for Expats?
Ah yes, the Individual Shared Responsibility Provision of the Affordable Care Act. I’d wager that most U.S. taxpayers by now are familiar with the tax penalty for not having qualifying/essential health care coverage for everyone in their household each tax year.
First of all, I want to say, I hate this provision with a passion. However, what I hate even more is that millions of Americans still don’t have access to truly affordable health care. Heck, if you think about it, most Americans have zero access to AFFORDABLE health care. I still believe that some sort of practical single-payer system is feasible in the U.S. and the only REAL way to achieve TRULY AFFORDABLE care for all. With that said…
The thing that really burns my britches about ACA and taxes is the provision (OR LACK THEREOF) for Americans abroad.
I mean, good grief.
This has been the bane of our existence for years now. If you’ve been following us for a while, you know that for the past several years, we’ve spent multiple months working or traveling outside of the U.S. During those periods overseas we generally have some sort of health care coverage. But is that coverage considered qualifying coverage for tax purposes? NOPE. In fact, there aren’t really any affordable plans out there that qualify in this respect; leaving many expats forced to pay a big fat penalty that keeps getting bigger every year — we’re talking thousands and thousands of dollars for a small family. You want to know why so many otherwise law-abiding American expats don’t file their taxes? Well, that’s a big part of it.
So what’s the alternative?
Well, if you meet the basic eligibility requirements for the foreign earned income exclusion (regardless of whether you actually earned income), you’d generally meet the requirements for an exemption to the ACA provision.
That’s us in 2017 — Yay!
There are also a number of other exemptions you could qualify for (including the short coverage gap which we utilized last year), but we wouldn’t have qualified for any of them this year.
If you’re away from the U.S. only half the year and don’t qualify for any of the other exemptions, you’ve got three choices:
- Purchase a qualifying health plan for your entire family from the Marketplace (have you seen the premiums for families on even high deductible plans!!!???) that you likely won’t even be able to benefit from half the year;
- Pay the penalty;
- Or, the cheapest (and riskiest option), don’t file and take your chances.
If you’ve gotten this far, you may be curious about…
Expat Self-Employed / Freelancers / Independent Consultants / Digital Nomads
I’ve been dipping in and out of this for years, but find myself still learning new stuff all the time. I’ve found that reporting self-employment (SE/1099-MISC) income can be straight-forward or incredibly complicated, depending on the circumstances. I think the most important thing to know regarding living overseas is that self-employment income does qualify for (and count towards) the Foreign Earned Income Exclusion (provided you meet one of the two tests and that your individual AGI is under the max — generally, you’ll be liable to pay taxes on any AGI over the max, regardless of the source).
You are still obligated to pay Self-Employment Tax (essentially, pay into your Social Security and Medicare).
I’ve heard all sorts of stories from many an elder self-employed American expat who didn’t bother filing tax returns for years because they thought they didn’t owe any taxes — then came to find that when they reached their sixties and went to take advantage of their Social Security and/or Medicare benefits…they were pretty much sh*t out of luck. You can’t claim the benefits if you don’t pay into the system!
Now, as to whether or not there will be anything left in the system for Lori and me when we reach that juncture is anybody’s guess…but we’ll leave that discussion for another day.
So that’s pretty much our experience. If you’ve got complex expat tax questions, DON’T ASK ME, ask a professional (or even cheaper, start off sifting through the arcane treasure trove that is the IRS website).
Helpful Resources for U.S. Overseas Taxpayers
Cover photo by Christine Roy on Unsplash.