FIRE for US expats: what does it mean? Well, for those who weren’t in the know already, FIRE stands for financial independence, retire early. Our advice below is aimed toward helping you avoid the mistakes that can make FIRE for US expats impossible. While there are numerous ways to maximize your financial savings as an expat, we’ve compiled a list below of several mistakes that should be avoided at all costs!
Do Not Invest in Foreign Mutual Funds
While it’s perfectly fine for a US expat to invest in foreign or emerging-market mutual funds or ETFs using a US broker, purchasing such investments from a foreign broker can cause the investment to be considered a PFIC, or Passive Foreign Investment Company.
A PFIC is considered a foreign corporation if it meets either an income or an asset test.
- Income Test – At least 75% of the corporation’s annual gross income is categorized as investment-type income (interest, dividends, capital gains, royalties, etc.).
- Asset Test – At least 50% of the average percentage of its assets produce or are held to produce passive income.
If you are a direct or indirect shareholder of a PFIC, you must file Form 8621 with your US expatriate taxes each year that you:
- Have a gain on a direct or indirect disposition of PFIC stock, or
- Receive certain direct or indirect distributions from a PFIC, or
- Make an election reportable on Form 8621.
Form 8621 adds a significant and costly tax reporting burden for your tax filings and can lead to some punitive taxes as well. It is generally wise to avoid such investments as it is one of the most costly mistakes that you can make and will certainly hamper the path toward FIRE for US expats.
Do Not Invest in Foreign “IRAs”
Expats need to be careful about investing in foreign plans that are described as or sold as being like US IRAs. While these investments may be tax-deferred accounts that use investments and appear to be similar to IRAs, that doesn’t mean the IRS views these as such. In many cases, the IRS views these types of accounts as foreign grantor trusts, and the consequences in taxation and reporting can be complex.
A trust is considered a grantor trust when the grantor retains a certain degree of dominion and control over the assets of the trust and is thus treated as the owner of the trust for US federal income tax purposes. As a result, the owner of the foreign trust will be subject to US income tax each year on the portion of the trust income he or she is considered to own. To make matters worse, the owner must also file Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, to report any transfers to a foreign trust.They must also file the form (Form 3520) annually to report ownership of the foreign trust— even if no transfer is made to the trust in that year.
To make matters worse, the trustee of a foreign grantor trust with a US owner must file Form 3520-A, Annual Information Return of Foreign Trust with a US Owner, with the IRS each year. Form 3520-A is due on March 15th, though a six-month extension for Form 3520-A may be requested. The trustee must also send a “Foreign Grantor Trust Owner Statement” to each US owner of a portion of the trust and a “Foreign Grantor Trust Beneficiary Statement” to each US beneficiary who received a distribution during the taxable year. If the trustee does not file Form 3520-A as required, penalties are imposed on the US grantor. To avoid penalties, the US grantor may sign and file Form 3520-A.
Keep in mind the previously mentioned PFIC problem: if the trust holds such investments, Form(s) 8621 and associated tax would also have to be filed with the return. This can create a tax-filing nightmare and can make FIRE for US expats more difficult.
Knowing what type of account you’re investing in and the consequences of doing so is imperative. It’s better to know in advance so you can avoid this or accept it if you’re willing to endure the filings and potential taxation. This can help make FIRE for US expats a reality.
Don’t Open Unnecessary Foreign Accounts
While opening a foreign account as a US citizen abroad isn’t a taxable event (and is necessary and convenient in most cases), some expats find they have opened so many accounts that the annual reporting and compliance obligations in the US become burdensome.
FBAR Reporting
The Foreign Bank Account Report (FBAR) is used to report all foreign bank account information to the IRS. It must be completed by all US individuals and companies with more than $10,000 in foreign bank accounts at any point during the year. The deadline is October 15th for US expats. Once that threshold has been exceeded, every foreign account held by the expat must be included on the FBAR, such as bank accounts, retirement accounts, pensions, investment accounts, etc.
FATCA Form 8938
Enacted in 2010, FATCA requires Americans with foreign financial accounts exceeding certain thresholds to file Form 8938 with their expat tax return. The thresholds are significantly higher than that of the FBAR but include a wider array of foreign accounts that must be reported.
You must file Form 8938 if you meet any of the following thresholds depending on your filing status:
- Single or Married Filing Separately – The total value of your foreign assets is greater than $200,000 on the last day of the tax year or more than $300,000 at any point during the year.
- Married Filing Jointly – The total value of your foreign assets owned by you and your spouse is greater than $400,000 on the last day of the tax year or more than $600,000 at any point during the year.
Form 8938 is due along with your expat tax return by June 15th, unless you file for an extension to the October 15th deadline.
Don’t Forget to Utilize the Foreign Tax Credit in Creative Ways
Many countries have a higher tax rate than the US. As a result, taxpayers utilizing the Foreign Tax Credit to offset US tax on that income wind up carrying over additional unused tax credits. These can be carried over for up to ten years. This is helpful when considering that expats may have to take a distribution of foreign pension income upon leaving the foreign country and will end up with a large tax liability for the year if there’s a sudden bonus payment or another windfall.
However, the credits can be carried over, aren’t country-specific, and can be used creatively if the expat stays abroad or moves back to the US.
If an expat stays abroad (or returns abroad after being back in the US for a few years), but is sent on an assignment where he or she doesn’t pay taxes to the country they’re living in, the accrued foreign tax credits from prior years can be utilized to offset tax liability created from the new assignment. The FEIE may still be an option, as well. If an expat returns to the US but travels abroad for work significantly, they may be able to allocate compensation earned on longer business trips to the countries worked in since compensation is sourced to the country where the work was performed. Then, they can utilize some foreign tax credit accrued for the percentage of working days he or she spent abroad.
Only Own Foreign Real Estate in Appropriate Situations
Living abroad, if you choose to purchase a home, the simplest way is to own the property individually. Typically, owning real estate abroad is treated the same as owning the property in the US. You’re entitled to deduct mortgage interest and taxes if you qualify (i.e., it’s your main home for two years).
In some situations, owning the property through a corporate structure may be desirable. If a corporate structure owns the property, the corporate tax laws for calculating gains and distributing profits are entirely different from personal tax laws for both your country of residence and the US. This may result in higher or lower total tax than owning as an individual, depending on the situation.
This can also create additional tax-filing complications, however. If you own at least 10% of the shares or control 10% or more of the voting rights, you’d need to file Form 5471: Information Return of US Person with Respect to Certain Foreign Corporations.
Another consideration is that, if the corporate structure is set up solely to hold the property, it may be classified as a passive foreign investment corporation (PFIC), subjecting you to the less-than-desirable complications mentioned earlier.
That said, the corporate structure could still be beneficial, as you may be able to have more deductions and more liability protections in the foreign country.
Carefully Plan Use of US Rental Properties
If you’re an owner of US rental properties, you can save on your taxes by avoiding certain mistakes. Generally, rental income is unearned income (and hence not eligible for any FEIE). However, if you perform personal services in connection with the production of rent, up to 30% of your net rental income can be considered earned income and is then eligible for the FEIE.
Further, the IRS issued Rev. Proc. 2019-38, which finalized a safe harbor for taxpayers who are direct and indirect owners in rental real estate enterprises. If you qualify for the safe harbor, your rental activities will qualify as a business and that the rental income will be eligible for the 20% section 199A deduction of qualified income from a business operated directly by a taxpayer or through a pass-through entity. Even if you do not qualify for the safe harbor, you may be able to use facts and circumstances analysis to support the 20% deduction. To do this:
- Maintain separate books and records for each rental real estate enterprise,
- Perform 250 or more hours of rental services each year, and
- Beginning in 2020, real estate enterprises must maintain contemporaneous documentation like the way a law firm might track time spent on client matters.
You should document the following items to satisfy the 250-hour requirement:
- Hours of services
- Description of services
- Dates such services were performed
- Who performed the service
This deduction, part of the 2017 Tax Cuts and Jobs Act, can be beneficial to expats with US rentals. It can also help FIRE for US expats seem more doable.
Don’t Forget to Set Up a Foreign Entity If Self-Employed
In the example we used of self-employed individuals, we mentioned how income tax could be significantly reduced—if not eliminated—by maxing out 401(k)s, hiring a spouse, and electing the maximum FEIE. The only downside was that self-employment tax would still apply. There is a way to avoid these mistakes, however.
If you instead choose to set up a foreign company and hire yourself as an employee, you are no longer considered self-employed and are now considered an employee of a foreign company. Employees of foreign companies do not have to pay self-employment tax. So, if Jane D. Expat decided to set up a Belize LTD company or other foreign entity, and the earnings of the company were up to her FEIE amount coupled with her standard deduction, and all was paid out as wages to her during the year, no self-employment tax would be due.
However, this scenario can be precarious as well because there are downsides. First, by not paying into the US Social Security system, you’re not likely to be able to get much out of it during retirement either. Besides, you could create complex tax and filing requirements in the foreign country as well. Finally, and perhaps most compellingly, the US requires owners of a CFC (or Controlled Foreign Corporation – a foreign company in which US citizens own more than 50% of the company) to both report that interest on Form 5471 with his or her tax return, and also potentially pay “GILTI” tax on any retained earnings and profits. These are legitimate concerns. But, all situations are unique, and you could find that this type of scenario is the strategy you need. For example, Belize companies are relatively easy to set up and administer, and, if you’re an older expat with a business that nets around the FEIE limit each year who has already paid substantial Social Security contributions, this could be a perfect fit for you toward the goal of FIRE for US expats.
Don’t Get Caught with State Taxes Back Home
Expats should be careful to consider state requirements in order to avoid common pitfalls. You’ll need to be aware of specific rules depending on your home state. In some cases, you won’t need to file state tax if you’re living abroad. A few states don’t have state income taxes at all. Here’s how to know if you need to file:
- Determine if you’re a resident of the state or if the state considers you a resident for tax purposes. This would be determined by the following:
- You lived in the state at any point during the tax year.
- Your immediate family lives in the state while you’re overseas.
- You return to the state each time you return to the US to live.
- You maintain an abode in the state (a permanent place of residence).
- You keep your driver’s license or ID card or voting rights in the state.
- Determine if you have income in the state:
- Income earned from working in the state is almost always taxable in the state.
- Other income generated from a state source – like pension/retirement income or government benefits – may be taxable if you’re a resident of the state.
- Residency requirements are determined by the individual state, but most states consider you a non-resident if you live outside the state for more than half a year.
Some states honor the exclusions while others do not, so knowing where you stand from a state perspective is advised.
Many strategies are available to maximize tax savings, help with financial planning, avoid costly mistakes, and make a plan toward FIRE for US expats. Working with experts who can understand your unique plans and goals will help you formalize a plan to navigate these matters proactively, and help you to breathe easier knowing you’re in compliance.
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