Episode 25 - Us Expatriate Tax Planning, Part 2
In ABCast Episode 25 – US Expatriate Tax Planning – Part 2 Janathan Allen discusses additional important tax issues from the perspective of a US expatriate. One of the first and most important thing to know for any US taxpayer is the United States taxes its citizens on all income they earn worldwide. US expatriates who remain US citizens (do not renounce their citizenship) remain US taxpayers. Unfortunately, many US expats (and even US taxpayers in general) believe one does not have to report offshore income to the IRS and California. This simply isn’t true.
Jan
Welcome to AB Cast, integrating Legal Tax Accounting and Business Solutions. I’m Jonathan Allen.
This episode is Expatriate Tax Services, Part 2
Neil
So let’s shift the conversation to real estate. Most people that are expatriates are going to have real estate either for investment or for their personal or both. So one of the things they may not realize goes back to the FBAR element. So if I have a bunch of money in the US and I bring it over to France where I’m living to buy a home, I’m going to have a bunch of money in a bank account, which immediately triggers FBAR reporting, which I may not be aware of. So can you talk a little bit about real estate transactions from the point of view of a US expat?
Jan
Well, real estate transactions are fairly similar to what they are in the states. I think where some people get tripped up is if they’re transporting funds and they leave the United States, they’ve been earned in the us maybe someone’s had a job, it could be a pension, it could be virtually anything.
Neil
They sold the house, whatever,
Jan
And then they take the funds and they move them across the pond, if you will. What ends up occurring is the moment that those funds hit a bank, then that becomes FBAR reportible event, and I think there’s not a lot of thought that’s given because the income was earned in the us How could it be foreign income? It’s not foreign income. It’s where it is that the income is held. So it becomes a reportible event because it’s now foreign held and it’s outside of the United States.
Neil
And let’s cover an FBAR basic: What we’re talking about also is the accumulated balance of all accounts that you have even for an hour. If it exceeds a given amount, it’s a triggerable event. You’re going to have to file an FBAR and you have to list every account and interest that you hold.
Jan
The thing that some people might feel is that if they bring the cash over from the United States, put it into a foreign bank account, and then purchase, let’s say a real estate property somewhere outside of the us, that because that income was utilized to purchase a property, that there is no reporting event. But the moment that any sort of bank account exceeds $10,000, it is a reportable FBAR event and it needs to be included in the filing of the tax return.
Neil
And it’s not just that account, it’s as a result of that one account going over 10,000, or the aggregate balance of all accounts, you must disclose every account. Correct.
Jan
So let’s clarify this. It’s not just a single account. Let’s say I have five accounts and the limit in that account is $7,500 and I have $7,500 in each of the five accounts. Some people feel that because those accounts haven’t exceeded that $10,000 threshold that they don’t have to report them, and that’s not true. It’s the aggregate amount that’s held within foreign accounts. Once that exceeds $10,000, then all of the accounts are reportable.
Neil
So either if one goes over or the combination of all, we have an immediate FBAR requirement. (Jan: That’s right.) Very good. Let’s talk about rental income. So if I’m a US expat and I have a rental property, how do I report rental income?
Jan
Same way you do here in the states, and interestingly enough, while a lot of the deductions that may be allowed in the states might not be allowed in the foreign country, we are allowed to take those types of deductions here in the states.
Neil
Amortization is one of those…
Jan
Amortization … depreciation. All of the deductions that are allowed in the US for rental properties are allowed when you own foreign properties as well. The interesting thing is oftentimes in a foreign country what’s reportable is different than what would be reportable here in the states
Neil
Yes. So how do you guide our clients through the issue of double taxation and the way to structure those so that you’re not paying tax in both locations jurisdictions?
Jan
Well, that’s where the tax credit comes in. So what ends up occurring is if you’re paying tax in a foreign country, and the interesting thing is there’s a lot of foreign countries that don’t tax rental income, but to the extent that it is taxed, then what ends up occurring is any foreign tax that is paid and it’s a computation on form 1 1 1 4, which is the tax computation that leads to the credit that’s applicable against the US tax. So what ends up occurring is there’s different types of income. There could be passive income such as rental income, active income, it could be salaries, whatever it is. And the varying types of taxes that is associated with each goes back and leads into the computation of the foreign tax credit that’s applicable against US tax. So while it may be reportable in both countries, the fact is there will be a tax credit that will be available, assuming that there are taxes that are paid on that same income.
Neil
If depreciation is not allowed in the country in which they reside, does that create an opportunity for a loss on a US tax return
Jan
Sure it does, because of course depreciation is a non-cash expense, but it is allowable as long as we have the purchase documents that show what the property was purchased for, and we can do an allocation between land and the improvements, we have the opportunity to take a depreciation expense for foreign property as well.
Neil
Great. Then there is an exclusion. So if I have foreign real estate and I sell it, there is an exclusion both for an individual and for a married couple filing jointly that I don’t have to pay taxes on the full amount of the proceeds
Jan
Well, that’s only if you lived in the property. So if the property that you’ve purchased is not rental property, but it is your personal residence, then yes, there is that exclusion. But if it’s rental property and you sell it, that exclusion does not exist because the exclusion extends to the personal residence of the couple or the individual, not rental property.
Neil
Let’s shift the conversation, Jan, to more of a general international tax type of discussion. You’ve kind of hinted at these treaties and the tax credits. How do tax treaties, the US has tax treaties with 70 some odd countries and then each country has their own blend. How do you as a tax professional counsel our clients on how to balance tax treaties and tax credits to avoid the issue of double taxation?
Jan
There’s really a hierarchy. So tax credits are, it’s a fairly computational event. Tax treaties, Trump virtually everything. So there can be items that in a bilateral tax treaty between the United States and some country where some forms of income that might be taxable here in the US where it not for the treaty would be taxable, but for the treaty won’t be taxable. So it’s really incredibly important that the individuals that are living in a foreign country understand what that bilateral tax treaty with the United States says. So once we go through the hierarchy of what it is, a bilateral tax treaty will deem to be taxable here in the states as opposed to in the foreign country.
Then we go back to the code and then what are the rules that go back and regulate the income that is reportable? So it’s really a two-step process. In every instance, the tax treaty, if there is one, and the US does not have tax treaties was some countries in the world, but to the extent that it does the tax treaty controls
Neil
And it is a dollar for dollar tax credit generally speaking.
Jan
So that’s sort of a misleading question
Neil
Then lead me!
Jan
Yes. When you do the tax computation, the credit for the taxes is dollar for dollar against the taxes computed in the us, but the tax computation itself is dependent based on foreign income and US income and worldwide income. So it really is a fraction, if you will, and there’s timing differences that can occur. But once the computation has been completed, whatever that computation is for the foreign income, the amount of credit that comes off of form one four is directly creditable against US tax.
Neil
So we’ve kind of brushed across several forms that a US expatriate might face in a tax situation. You’ve talked about form 5471, it’s a form that’s an informational return basically for those who have certain foreign corporations. Can you talk to us about when someone should be thinking about 5471 and what types of situations we face where it’s an absolute, we’re going to be using this form?
Jan
Well, form 5471 is applicable anytime a US individual taxpayer, whether they’re an expat or whether or not they’re living within the United States. Anytime you have an interest in a foreign entity, 5471 is going to trigger depending on the type of entity that you’re involved in. There are types of entities where we have here in the United States, an individual starts a company, but there is no company. They’re reporting everything on a Schedule C. So there’s no formal entity to the extent that that occurs in Europe or wherever else an individual may be investing. That’s going to pose all sorts of different problems. But to the extent that they are investing in entities, then the 5471 is predicated based on the amount of interest owned within the company, and then the income that’s earned from that foreign entity, whether it’s distributed or not, is a deemed dividend based on the percentage owned by the US individual. And that will be reportable
Neil
Form 8621 is for shareholders that hold a PFIC or a qualifying electric fund. I think the first council would be avoid PFIC’s like the plague. But can you talk about passive foreign investment corporations or companies and why this is such a terrible idea for a US taxpayer or a US expatriate?
Jan
Well, now you’re getting into the complex world of really the baskets that the code has gone back and divided foreign income into. So an American can hold an interest in a foreign company, and it depends on what that foreign company is doing. So let’s say you invest in a company and it’s a high tech company and it’s out there producing some widget or some sort of product, whatever that is, that’s known as an active income company. And the active income companies are less arduous in terms of reporting than companies that an individual may invest in that are really investing in something else that throw off passive income. So think of a company that goes in and invests in real estate or passive real estate, and the income that flows through is not income that is coming from assets that are managed, but from investments in those assets. That’s the passive income component. And when you start getting into that part of the code is called sub part F,
Neil
We won’t say what F stands for.
Jan
It becomes a very, it’s a very complex analysis as to what it is. It’s going to have to be paid and when, so whenever an individual goes back and owns ownership or has ownership in a foreign company, the type of company, whether it’s an active company, it’s an operational company, or whether it’s investing in passive income, can make a great deal of difference in terms of taxes and the amount of taxes you pay
Neil
What’s the tax rate on a PFIC investment?
Jan
Oh, you don’t want to know.
Neil
and they don’t want to know either, right?
Jan
The taxes for Subpart F Income can reach 55%!
Neil
Wow. Okay, Foreign Trusts, form 3520. When is this going to come into play?
Jan
Oh my goodness. Virtually lots of times. Lots of times that people don’t think about. So think a client came in the other day and we were doing a streamlined submission on their behalf, and we find this particularly in the uk, Canada, Ireland, New Zealand and Australia, those are the countries that will have pensions, for example, that do investments in mutual funds. And because those mutual funds and those pensions are generally held as a trust instrument, and the organizing document which we go back and have to obtain is generally a trust. That’s when formed, 3520 is triggered and the form 3520 again goes back and triggers a deemed income event in the appreciation of the asset. So what people don’t understand and what is fairly complicated because I mean retirement accounts even in the states are complicated, but then you move outside the United States and now you’ve got a pension that’s held within a trust that’s invested in mutual funds, you’ve got some really difficult tax analysis that needs to occur in order to affirm that you are filing the tax returns appropriately and correctly
Neil
I am going to shift a little bit away from the financial picture to a personal issue. Getting married when you’re overseas. So how do you file? Are you going to file as a single? Are you going to file as a filing jointly or separately or all the above? Ask your tax professional. What happens when you fall in love overseas?
Jan
Well, it’s not as easy as it sounds generally when people go and get married, and let’s say you go and you have a romantic Italian wedding and you see a lot of stars that go back and they’ll go to your of somewhere and get married in a beautiful castle or on Lake Cuomo, whatever.
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Neil
Yeah.
Jan
The issue is most times people will come back and they will have a license and get married in the states as well. And the reason for that is you want the marriage to be recorded in the states so that you have that marital status. That does not mean that if you are coming, let’s say you were overseas and you happen to get married, and then you and your spouse come back to the states and you hold yourself out as being married, that doesn’t mean that you’re not, and it doesn’t certainly mean that you have to get married in the States.
But when it comes to divorce, it becomes far more complicated because in the United States, when one gets a divorce, the divorce is predicated based on the state in which you were married. And so what ends up occurring is if you weren’t married in any of the states, what state is going to control and what law controls.
So we had this issue arise with an individual who happened to come from a South American country and in South America there are differing types of marriages. So you can get married by contract or you can get married in the church. You’re equally married under the law in the South American country. But the fact of the matter is there are two different types of marriage. So when you leave and you come to the United States and now suddenly you want to get divorced, the question is how do you get divorced? What law controls, what is it that you should do?
And we’ve had that arise in terms of what it is that we do. And I’ve come to the conclusion that while I think a transmutation agreement would suffice, I think in the event that there was any acrimony anywhere down the line, that the transmutation agreement and the agreement between the estranged spouses were ever to come into conflict or go into court that could pose a problem, but it’s not as clear cut as it looks.
Neil
Jan. Finally, we come to the idea of 401Ks or other retirement accounts. Let’s say they worked here in the United States and they’ve reached the point where they’re out, I’m done. I’m going abroad, I’m going to live abroad, or I’m going to travel abroad, whatever. Now we’re an expat, we’re traveling the world, or we’re living and working abroad, but we have 401k or retirement vehicles here. What happens when they start making withdrawals from an American retirement asset?
Jan
So as you can well anticipate, it will be taxable in the United States depending on the amount of course, it was contributed by the individual tax-free in which was deferred. And if there was, for example, for a pension, anything that was matched by an employer, to the extent that the pension or the 401k has withdrawn, its taxed here in the United States, it generally is not taxed in the foreign country. Same thing with foreign retirement. For example, if a US citizen has lived and worked in a foreign country and developed a pension there, it’s generally the bilateral tax treaties that will go back and control, but the retirement income is generally taxed in the country in which it was earned. That’s sort of a general rule of thumb. There are exceptions, but as a general rule, the retirement income is taxed in the country in which it’s earned
Neil
For expats that have left California, they may be in for a surprise about how California views those retirement funds.
Jan
Yes, it could. California has a very long reach, depending on how long it’s been since someone has had ties in the state of California and how long the aggregate investment occurred that was occurring in the state of California. California has been known and could reach out and say, we think a portion of your retirement is taxable here in the state.
Neil
So to sum up our conversation for U.S. expats, first of all, our love and admiration for the adventure in your heart and the financial challenges that you face, but how important is it to have someone they can turn to that can advise them on legal tax, estate planning, accounting, all the above.
Jan
So it’s as important as if you were living in the states, so to the extent that you would have a tax advisor, financial advisor here in the States, then it’s equally important that once you leave the states that you have the same sort of individual that can bridge the gap between what’s going to happen based on the transactions that you have both in the foreign country that you’re living in and in the United States because the world is getting smaller, but it’s not so small that there isn’t tax in both places.
Neil
And what words of advice would you have for someone who’s woken up to the idea that, oops, I may have missed some or many of my reporting obligations?
Jan
Yep. That’s something that we deal with on a daily basis. There are remedies for that. It’s called the streamlined submission, and the streamlined submission is bringing you up to date current so that there are no penalties that could be assessed in the event that the IRS were to find that there had been a non-reporting event and put you under audit because the civil penalties for the failure to report foreign income are very, very severe.
For example, if you have an FBAR account and you haven’t filed the FBARs, we had an individual the other day that we took on and they had 16 foreign bank accounts. They hadn’t reported those bank accounts for the duration of the time that they were outside of the United States, which was approximately nine years. And so they hadn’t filed the FBARs. If the individual were to be audited by the US government and declare those particular accounts, then what would happen is there is a $10,000 charge for each account for each year, and that’s the civil penalty.
Then because they have been unreported for so long, the IRS is open to the ability to prosecute someone criminally for failure to file a tax return and then failure to report for an income and foreign earnings. So the streamlined submission is designed to mitigate those really, really obscene penalties that can occur if you were to undergo audit. It’s not a simple procedure. It’s filing amended tax returns for three years and then filing FBARs for seven years, presuming that you’ve been out of the country or had foreign bank accounts for seven years.
And then there’s a non willful letter component that’s the legal component that goes back and explains to the Internal Revenue Service why you haven’t filed. And in the event that that occurs, then there’s of course the tax on any income, unreported income, but the penalty for holding assets outside of the United States is 5% of the fair market value of those assets, which is down considerably from the original offshore voluntary disclosure program, which was superseded by the streamline program in 20 17, 20 18. And the penalties under that program were 28% of the fair market value of the assets. So the streamlined submission is a way to come clean. It’s sort of a kind of get out of jail for free, but it’s a methodology to go back and come above board in the event that you failed to file and declare foreign income.
Neil
And I would like to just encourage anyone out there who’s listening, who’s weighing the question of, do I or don’t I? Once they find you, if you’re audited or if they open an investigation, all those avenues close. Now you’re on your own.
Jan
And the worst part of it is once you’re under audit, it may not be for the years in question, but the IRS once they know can go back and open an audit because what the assumption is from the auditors will be that there’s fraud. There’s an intent not to report so they can go back under that particular scenario. There is no statute of limitations.
Neil
Yes, with all of the reporting that’s coming into the IRS from around the world, investment houses, banks, sovereign tax agency, crypto exchanges, it’s not a question of if it’s a question of when and now they’re applying artificial intelligence to go through all of that data and all of the associated returns, it’s a lot easier and less expensive for the IRS to catch those differences.
Jan
I think you’ve hit the nail on the head, the advent of artificial intelligence to go through the reams of documentation, even tax returns that the IRS has held for so many years, they’re going to a non-paper system. So what will be far easier for them? That and the increase in their budget because that’s what they’re looking for. These types of failures to file are easy money to the IRS. It’s a failure to file. You didn’t do it. And to the extent that they can throw civil penalties at you, that can be just mind-numbing. For people that have any question about whether or not they should file or consider a streamlined filing, consider the alternative.
Neil
And the best way to start that is with a free consultation with Jan and Allen, and you can reach her at (866) 631-3470 for a free consultation or you can reach out to us through our website, https://allenbarron.com
Jan, thank you so much for the time today, and on behalf of us expats, we appreciate all the information you’ve provided.
Jan
You’re welcome. Learn more about our integrated legal tax, accounting and business solutions, and visit https://allenbarron.com or call (866) 631-3470 to schedule a free consultation.
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