A common strategy many wealth management firms recommend is ensuring that as much as 30% of your portfolio includes foreign investments and securities. What is the potential tax impact of foreign investments? One of the keys to maximizing the advantages of offshore investment involves management of the effects of taxation here in the U.S. and in the country where the investment is based.
The United States and many individual states, including California, tax the worldwide income of their citizens. If the nation where the investment is based taxes the income generated, should you be concerned about double taxation? How are capital gains (and losses) managed differently by the IRS when compared to foreign accounting and taxation standards?
It is important for savvy investors and investment advisors to remember that offshore investments and income are a primary area of focus for the IRS. The agency receives a significant stream of information about every U.S. citizen’s accounts, investments, transactions, and assets from Foreign Financial Institutions (FFIs), sovereign tax authorities, and even cryptocurrency exchanges and wallet services and vendors. The agency applies state-of-the-art computer technology and Artificial Intelligence (AI) to sort through this voluminous stream of information and tie individual data back to unique U.S. taxpayers. If you are under the impression that it is possible to hide offshore income and assets from the IRS in 2025, you might need to increase the scope and breadth of your research prior to investment.
Once you are aware of the risks and the genuine nature of the playing field, you are prepared to consider the options. There is undoubtedly a potential tax impact of foreign investments that U.S. citizens must weigh prior to investment. Yes, offshore capital gains are subject to taxation by the country or sovereign authority where the investment is based and income is realized, as well as here in the United States. However, in many cases, it is possible to offset U.S. tax liabilities with a foreign tax credit based on income taxes paid to foreign nations.
Every sovereign nation has its unique tax laws. Several countries outside the United States do not tax the capital gains of foreign individuals and entities. Others levy substantial income taxes on non-resident capital gains. Many European nations tax foreign investors on up to 26% of their income. This is why it is so essential to conduct thorough research. If you are considering an offshore investment, look into the local tax rates of the nation where the investment is based and any treaties that might exist between the United States and that nation.
Many nations have tax treaties with the United States to prevent double taxation of offshore income. Most U.S. taxpayers will also be able to deduct part or all of the net capital losses against other sources of income. U.S. taxpayers can often claim an itemized deduction or a tax credit associated with offshore income and capital gains. Credits are usually preferable, as they apply directly to the amount of taxes owed, compared to the actual value of the tax impact of an itemized deduction.
Ask our international tax attorney and tax advisor Janathan Allen about the impact of gains and losses within specific nations and how the tax credits and treaties for that nation apply to taxable income here in the United States. Foreign tax credits for individuals, married couples filing jointly, estates, or trusts are sought through IRS Form 1116. The instructions for this form are another source of information on the specific investment(s) you may be considering. This form is generally not required for individuals who paid $300 or less in applicable foreign income tax or $600 for those who are married filing jointly. In such instances, these amounts would be reported directly on the IRS Form 1040.
The potential tax impact of foreign investments is especially high for mutual funds and investments that generate most or all of their income passively. Therefore, U.S. investors considering offshore investment should carefully evaluate foreign mutual funds and other investments generating passive income.
One of the challenges of an offshore mutual fund relates to the underlying accounting and realization of income or loss. Generally speaking, most foreign nations only tax mutual funds when an asset within the fund is transacted, resulting in a gain or loss for the fund owner. In theory, if none of the assets within the foreign mutual fund were sold within a given tax year, there would be no income tax-related gain or loss generated for that tax year (and no income tax-related event). As a result, offshore mutual funds usually only provide detailed portfolio data when assets held by the fund are transacted, resulting in a gain or loss.
Income taxes associated with mutual funds in the United States are based on the net increase or decrease in the value of each asset in the fund (and the unique account holders/taxpayer’s interest in that fund) within a tax year. In order to determine taxable income or loss, U.S. mutual funds must provide detailed information on any assets sold within the tax year, as well as the value of each asset retained by the mutual fund at the beginning and the end of that tax year.
Therefore, U.S. taxpayers must also provide detailed tax reporting related to any gain or loss associated with the value of each foreign mutual fund asset held within their portfolio for the given tax year. Foreign mutual funds rarely provide this information. Consider the additional costs generated when the U.S. taxpayer’s accountant or tax preparer must research the value of each asset held within that foreign mutual fund investment, both at the beginning of the tax year, and again when the tax year comes to an end in order to complete the associated tax return(s).
Most nations will tax the account holder when income or losses are realized (through a transacted asset). U.S. income tax exposures are established by the capital gain or loss of the portfolio for the tax year, based upon the value of the assets within the portfolio at the start and those values at the end of the tax year, regardless of whether any transactions occurred or any actual gain or loss was experienced by the taxpayer.
Another potential tax impact of foreign investments arises when the U.S. taxpayer’s portfolio involves offshore passive income. Any foreign mutual fund or investment entity with at least one shareholder from the United States is usually designated as a Passive Foreign Investment Company or PFIC. If the offshore entity or investment generates 75% or more of its revenue from passive income or applies 50% or more of applicable assets to generate passive income, the entity will be classified as a PFIC. The IRS taxes PFIC income at a substantially higher rate than any other form of income or capital gains.
Foreign investors must also be concerned with FinCEN Form 114, commonly called an FBAR. U.S. taxpayers with over $10,000 in the aggregated total of all their FFI or offshore bank or investment accounts must file an FBAR annually. As the value of offshore accounts and assets increases, the U.S. taxpayer may also be required to complete IRS Form 8938, the Statement of Specified Foreign Financial Assets.
What is the potential tax impact of foreign investments? This question should be addressed by our international tax attorney and professional tax advisor Janathan Allen prior to investment. In many cases, foreign tax credits or itemized deductions can prevent double taxation on offshore income. However, each unique investment location’s tax laws and associated tax treaties must be analyzed and balanced in any investment decision. A U.S. taxpayer must evaluate the impact of foreign investment from the perspective of FBAR and IRS Form 8938 reporting requirements. It is prudent to understand the specific types of potential income, capital gains, and losses one may realize and how those events will reflect on the income tax reporting requirements and net tax exposure of any U.S. citizen or entity.
We invite you to learn more about the integrated tax, legal, accounting and business consulting services of Allen Barron and contact us or call today to schedule a free consultation at 866-631-3470.
