Is Unearned Income for Expats Taxable in the US?

Is Unearned Income for Expats Taxable in the US? 

When a US Person moves overseas and resides there a majority of the time, they are considered to be an expat (not to be confused with an expatriate, who is a person who formally gives up their US Person status) Generally, expats are not limited to US citizens but can also include Green Card Holders because technically a Green Card Holder is taxed the same as a US citizen –  at least for US tax purposes. Since an Expat resides outside of the United States, it is not uncommon for expats  to have invested in assets located in the foreign country that then result in earning passive income — such as interest, dividends, capital gains, real estate rental income, etc. In addition, many foreign countries exempt passive income from local taxes when the income is sourced in that same country. Unfortunately, the foreign exempt status of passive income does not generally apply under the US tax code — and therefore the foreign unearned income of Expats is typically taxable in the United States. Let’s go through some of the basics.

Worldwide Income

Unlike nearly every other country on the planet, the United States follows a worldwide income tax model. That means, that as long as a person is considered a US Person, such as a US Citizen, Lawful Permanent Resident, or Foreign National who meets the Substantial Presence Test –– they are subject to tax on their worldwide income. This would also include income generated overseas and even on earned income such as interest and dividends — which oftentimes will escape tax in the source country.

Income Does Not Need to be Distributed

Even if the unearned income that is being generated overseas is not distributed, that does not mean that the income escapes taxation. Rather, if the income is earned then it is taxable even if it is not distributed –– noting that if the income was generated by way of a PFIC, then there are much more complicated tax rules to be aware of, and while immediate taxation may be avoided the ultimate tax rate may be much worse.

You May Have Foreign Tax Credits

When expats have unearned income from overseas, it is important to note if that if they already paid taxes in a foreign country they may be able to apply foreign tax credits to reduce or eliminate the US tax liability on the foreign income. In addition, unused foreign tax credits can typically be carried forward for several years.

Long-Term Capital Gain and Qualified Dividend Rules Can Apply

The United States Tax Code provides for reduced tax rates for income that qualifies as either Long-Term Capital Gains or Qualified Dividends. Even if the income is generated overseas, if it would otherwise qualify as either Long-Term Capital Gains or Qualified Dividends — the taxpayers can still enjoy the benefits of those tax rules on their US tax return.

Treaty Election and Expatriation Pitfalls

When a person is a Lawful Permanent Resident and maintained the US status but resides overseas as an expat, they are taxed on their worldwide income. Nevertheless, they may be able to minimize or avoid these tax rules by making a treaty election to be treated as a foreign person. Noting, that if the person has already been a US person for eight of the past 15 years as a Lawful Permanent Resident and then they make the election, they may be subject to the expatriation rules — which can be very costly for expatriates considered to be covered expatriates.

Missed Reporting under Expat Amnesty Avoids Penalties

When a person missed the reporting in one or more prior years, the Internal Revenue Service has developed various foreign account amnesty programs to assist with getting into compliance safely. Out of all the different amnesty programs, the Streamlined Foreign Offshore Procedures (Expat Streamlined Amnesty or SFOP) offshoot of the Streamlined Filing Compliance Procedures, is generally regarded as the best program and is designed specifically for expats. Under SFOP, all tax and reporting penalties are waived.

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