We have a worldwide economy and with that comes a variety of tax issues. Some of these may be relevant to you. The following issues, some of which you may not be aware of, apply to individuals. In addition, some are subject to severe penalties when not complied with.
- Non-Resident Alien Spouse
- Foreign Rentals
- Foreign Pensions
- Foreign Income Exclusion
- Statement of Specified Foreign Financial Assets
- Credit of Foreign Tax Paid
- Canadian Registered Retirement Savings & Income Plans
- Reporting Receipt of Foreign Gifts or Bequests
- Reporting Ownership or Transactions with Foreign Trusts
- Annual Information Return for Foreign Trust with U.S. Owner
- Ownership or Voting Power in Foreign Corporation
Non-Resident Alien Spouse
It is becoming more frequent that a U.S. citizen or U.S. resident alien is married to a nonresident alien. In this circumstance the couple has filing options for U.S. tax purposes. Generally, a U.S. citizen or a U.S. resident alien (sometimes referred to as a green card holder) who is married to a nonresident alien must file their U.S. tax return using the filing status Married Filing Separate. This filing status has higher tax rates and certain limitations that do not apply to other filing statuses. The nonresident alien spouse would have to file a nonresident U.S. tax return on any U.S. source income.
However, tax law allows a person who is a nonresident alien at the end of the taxable year, and who is married to a U.S. citizen, or a U.S. resident alien, to be treated as a U.S. resident for income tax purposes and file a Married Filing Joint return, if both spouses so elect. In doing so both spouses must agree to subject their worldwide income for the taxable year to U.S. taxation.
Once made, and as long as one of the spouses is a U.S. citizen or resident alien, the election applies for the election year and all future years until it is terminated. If the election is terminated, neither spouse is eligible to make the election for any subsequent tax year.
Making this election requires a careful analysis of the tax ramifications of combining incomes, not only for the current year but all future years. Also, the couple could be subject to an FBAR filing requirement discussed later.
Generally, foreign rental property is reported on the U.S. tax return in the same manner as a domestic rental. However, there are some differences in rental depreciation. For residential property, if the property were in the U.S. the depreciable recovery period would be 27.5 years but for a foreign rental the recovery period would be 30 years straight line. Similarly, for commercial rentals 40 years instead of 39.5.
The passive loss rules apply to a foreign rental in the same manner as a domestic rental so any consolidated net losses are limited to $25,000 but this limit is reduced (phases out) for taxpayers with an adjusted gross income (AGI) between $100,000 and $150,000.
If the landlord hires a non-resident alien in the foreign country to perform services related to the foreign rental activity, there are no U.S. reporting or withholding requirements. However, the foreign person providing those services should complete Form W-8BEN and return it to the landlord as proof that the individual is not subject to U.S. taxation.
Last, but not least, if a foreign bank account is maintained to receive rental income and disperse rental expense payments, and the owner of the property has signature or other authority over the account, then there may be an FBAR reporting requirement discussed later.
A foreign pension or annuity distribution is a payment from a pension plan or retirement annuity received from a source outside the United States such as a:
- foreign employer;
- trust established by a foreign employer;
- foreign government or one of its agencies (including a foreign social security pension);
- foreign insurance company;
- foreign trust or other foreign entity designated to pay the annuity.
Just as with domestic pensions or annuities, the taxable amount generally is the gross distribution minus the cost (investment in the contract) unless there is a tax treaty provision covering the taxation of the pension.
Another issue is whether the pension is taxable to the U.S., the individual’s country of residence, other country or the pension’s country of origin. This is commonly determined by the tax treaty between the U.S. and the country of origin. Generally, most tax treaties allow the country of residence to tax the pension or annuity under its domestic laws. This is true unless a special treaty provision specifically amends that treatment.
The following are some commonly encountered treaty provisions:
- Canada – Canadian Old Age Security (OAS) pensions and Canada/Quebec Pension Plan (CPP/QPP) benefits received by U.S. residents are treated for tax purposes as if they were U.S. Social Security payments. U.S Social Security benefits received by a Canadian resident are taxable to Canada. Beneficiaries of a Canadian RRSP, RRIF, Registered Pension Plan, or deferred profit-sharing plan are taxable to the U.S. if the recipient is a U.S. Resident.
- United Kingdom – UK pensions received by a U.S. resident are taxable to the U.S. and U.S. pensions received by a resident of the UK are taxable to the UK. Each country can only tax the amount that would have been taxed in the other country.
CAUTION: These treaty provisions are with the U.S. Federal government and not with the individual states. Consult the individual state’s rules.
Foreign Income Exclusion
U.S. citizens and resident aliens are taxed on their worldwide income, whether they live inside or outside of the U.S. However, qualifying U.S. citizens and resident aliens who live and work abroad may be able to exclude from their income all or part of their foreign salary or wages, or amounts received as compensation for their personal services. In addition, they may also qualify to exclude or deduct certain foreign housing costs.
To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must:
- Have foreign earned income (income received for working in a foreign country, including payroll disbursements from a U.S. employer and self-employment income);
- Have a tax home in a foreign country; and
- Meet either the bona fide residence test or the physical presence test.
The foreign earned income exclusion amount is adjusted annually for inflation. For 2021, the maximum is $108,700 ($112,000 for 2022) per qualifying person. If the taxpayers are married and both spouses (1) work abroad and (2) meet either the bona fide residence test or the physical presence test, each one can choose the foreign earned income exclusion. Together, they can exclude as much as $217,400 for the 2021 tax year ($224,000 for 2022), but if one spouse uses less than 100% of his or her exclusion, the unused amount cannot be transferred to the other spouse.
In addition to the foreign earned income exclusion, qualifying individuals may also choose to exclude or deduct a foreign housing amount from their foreign earned income. The amount of qualified housing expenses eligible for the housing exclusion and housing deduction is generally limited to 30% of the maximum foreign earned income exclusion. The housing amount limitation is $32,610 for the 2021 tax year ($33,600 for 2022).
Generally, to qualify, most individuals use the physical presence test which requires the taxpayer to be physically present in a foreign country for 330 full days during a consecutive 12-month period (not a calendar year). Where the 330-day period overlaps two years the exclusion is prorated for each year.
Foreign Account Reporting Requirements (FBAR)
All United States entities (including citizens and resident aliens as well as corporations, partnerships, and trusts) with financial interests in or authority over one or more foreign financial accounts (e.g., bank accounts and securities) need to report these relationships to the U.S. Treasury if the aggregate value of those accounts exceeds $10,000 at any time during the year. Failure to file the required forms can result in severe penalties.
The U.S. government wants this information for a couple of pretty obvious reasons. One, foreign financial institutions may not have the same reporting requirements as U.S.-based financial institutions. For example, they probably won’t issue the 1099 forms to report interest, dividends and sales of stock. By requiring those in the U.S. to divulge their foreign account holdings, the IRS can more easily cross-check to see if foreign income is being reported on the individual’s tax return. The second (and probably more significant) reason is that the information in the report can be used to identify or trace funds used for illegal purposes or to identify unreported income maintained or generated overseas.
This reporting requirement is not included with a tax return but is a separate filing with the U.S. Treasury’s Financial Crimes Enforcement Network. The due date of the report is the same as the April filing date for individual tax returns, April 18, 2022, for 2021 returns (except for residents of Maine and Massachusetts where the due date is April 19, 2022), and there is an automatic extension to the October individual extended due date, October 17, 2022, for 2021 returns.
A civil penalty of up to $10,000 may be imposed for a non-willful failure to report; the penalty for a willful violation is the greater of $100,000 or 50% of the account’s balance at the time of the violation. Both the $10,000 and $100,000 amounts are subject to inflation adjustment, which, as of January 24, 2022, brings them to $14,489 and $144,886, respectively. A willful violation is also subject to criminal prosecution, which can result in a fine of up to $250,000 and jail time of up to five years.
CAUTION: On Schedule B of the Form 1040 tax return, you must state whether you have a financial interest in or signature authority over one or more foreign financial accounts. If you answer yes but don’t file the FBAR, your failure to file may be considered willful, which could subject you to the larger fine and jail time.
You may have an FBAR requirement and not even realize it. For instance, say that you have relatives in a foreign country who have put your name on their bank account in case of an emergency; if the value of that account exceeds $10,000 at any time during the year, you will need to file the FBAR. The same would be true if your name was added to several of your foreign relatives’ smaller-value accounts that add up to more than $10,000 at any time during the year. As another example, if you gamble at an online casino that is located in a foreign country and your account exceeds the $10,000 limit at any time during the year, you will need to file the FBAR.
Statement of Specified Foreign Financial Assets
You may also have to file IRS Form 8938, which is similar to the FBAR but applies to a wider range of foreign assets and has a higher dollar threshold. This form is filed with your income tax return. If you are married and filing jointly, you must file Form 8938 if the value of your foreign financial assets exceeds $100,000 at the end of the year or $150,000 at any time during the year. If you live abroad, these thresholds are $400,000 and $600,000, respectively. For other filing statuses, the thresholds are half of the amounts above. The penalty for failing to file Form 8938 is $10,000 per year; if the failure continues for more than 90 days after the IRS provides notice of your failure to file, the penalty can be as high $50,000.
Credit for Foreign Tax Paid
With the worldwide economy we are all living in, more and more individuals are making investments in foreign countries, and may pay a foreign tax on their foreign earnings. These earnings are also taxable to the U.S. To compensate for potentially being taxed twice on the same income, the U.S. allows a tax credit, or an itemized deduction if the taxpayer itemizes their deductions, for the foreign income taxes paid. CAUTION: if you are a partner in a partnership or a shareholder in an S corporation you should contact your managing partner or shareholder before filing a Form 1116 to claim a foreign tax credit. Filing the Form 1116 on your 1040 or 1040-SR can have ramifications related to the filing of the partnership or S corporation tax returns.
Reporting Receipt of Foreign Gifts or Bequests
Foreign gifts or bequests received by a U.S. person, other than an exempt organization, must be reported to the federal government on Form 3520 if the gift exceeds $100,000 from a nonresident alien individual or a foreign estate, including foreign persons related to that nonresident alien individual or foreign estate.
In addition, amounts more than $16,815 for 2021 ($16,649 in 2020 and $17,339 for 2022) from foreign corporations or foreign partnerships, including foreign persons related to such foreign corporations or foreign partnerships, that are treated as gifts must be reported on the Form 3520.
Reporting Ownership or Transactions with Foreign Trusts
Form 3520 is also used to report ownership in a foreign trust or transactions carried out with a foreign trust. Failure to file Form 3520 or providing incomplete or incorrect information can be subject to some severe penalties.
Annual Information Return for Foreign Trust with U.S. Owner
A foreign trust with a U.S. owner must file Form 3520-A in order for the U.S. owner to satisfy its annual information reporting requirements. Each U.S. person treated as an owner of any portion of a foreign trust is responsible for ensuring that the foreign trust files Form 3520-A and furnishes the required annual statements to its U.S. owners and U.S. beneficiaries.
Ownership or Voting Power in Foreign Corporation
Generally, a U.S. citizen or resident alien (or one who files a joint return with a U.S. citizen or resident alien) who owns a 10% or more interest in a foreign corporation or commands control over more than 50% of the voting power in a foreign corporation must file Form 5471.