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The following is not legal advice. Contact a tax attorney and international CPA should you have specific questions.
“So you live on a tropical island now?” While traveling, many of us have encountered expats living abroad who inspire us to consider packing our bags and doing the same. Beyond the usual concerns that come from making this choice — like finding a place to live, figuring out the visa requirements you’ll need to stay there or wondering what might happen if you ever got locked up abroad — is the most daunting question of them all: What about paying Uncle Sam?
Contrary to popular belief, moving to the Caribbean will not relieve you of your tax obligations — the IRS will track you down no matter where in the world you go. When I moved to Mongolia three years ago to work as a foreign registered attorney, I opened a local bank account. There was no welcome bonus for being a new account holder; in fact, I was greeted with a stack of forms. Even in Ulaanbaatar, the tax man is on the prowl.
So what should you do if you want to live overseas and limit your tax liability while remaining in the good graces of the US government? While each case is different, here are some starter tips in case you are thinking of making the jump from the cubicle to the Cayman Islands anytime soon.
Step 1: Understand the Foreign Earned Income Exclusion
In general, US citizens and resident aliens are subject to federal income tax on worldwide income. The Foreign Earned Income Exclusion (FEIE) allows qualified taxpayers to exclude from taxable income up to $101,300 of earned income subject to two requirements (more on that in the next step). It is important to note that the income must be earned from working, either as an employee or as an independent contractor, and does not apply to passive income such as interest, dividends, pensions or rental income. Also, independent contractors receiving a 1099-MISC might still be subject to self employment tax (Social Security and Medicare) on their net income. This can be optimized by opening an S Corp or other potential offshore structures depending on the person’s individual tax situation.
Step 2: Understand the FEIE requirements
Requirement #1: You must establish a “tax home” in a foreign country or in several countries. How does one do this? See Step 3, below.
Requirement #2: You will need to satisfy either the “Bona Fide Residence Test” or the “Physical Presence Test.” See Step 4, below.
Step 3: Have a Fire Sale
The easiest way to meet the “Tax Home” requirement is to cut ties with the US. This means giving up your apartment, selling your car or canceling the lease for your office, all with documentation that shows your intent to leave.
Step 4: Get Out…
The official IRS site describes the often cumbersome process of fulfilling the requirements for the Bona Fide Residence Test as follows: You must be a bona fide resident of a foreign country (or countries) for an uninterrupted period that includes an entire tax year. What this really means is that you will need to plant your flag in another place for most of the year. While you do not necessarily have to stick to one country like the confines of a jail cell, you will need to prove your intention to be there full-time. This is not very black and white, but some examples of proving your residency include:
- Establishment of a temporary home in a foreign country for an indefinite period (ie. by having a long term lease or owning a home there).
- General assimilation; participation in communities on the social and cultural level. So go ahead and get that library card and gym membership.
- Physical presence in the foreign country, meaning that you do have to be living there.
- Marital status and residence of the family — if you have a local spouse or family members there, it helps.
- Assumption of economic burdens and payment of local taxes.
- Other documentation such as health insurance, local bank account info or a drivers license.
The Physical Presence Test is more applicable to the new generation of expats, including digital nomads, who often jump from one country to the next. According to the IRS website, you just need to be physically present in another country for 330 full days over the course of a 12-month period. Note that the 330 days do not necessarily need to be consecutive. Basically, the test does not depend on the kind of residence you establish, your intentions about returning to the United States or the nature and purpose of your stay abroad, just the amount of time you are in another country. However, your intentions with regard to the nature and purpose of your stay abroad are relevant in determining whether you meet the “Tax Home” requirement mentioned in Step 3 (where you cut ties to your home in the US).
The main point is that someone can pick up and leave any day of the year — like July 1, 2017, for instance — travel the world, physically work in countries from their laptop and return home to the US one year later (on July 1, 2018) and as long as this person was in the US for under 35 days during this period, they would qualify for the FEIE and not have to pay taxes on the first $101,300 in earned income. In this case, the split would be divided prorate, so would be approximately $50,000 in 2017 and $50,000 in 2018 since the 365-day period was split between two calendar tax years.
It is also important to understand the tax implications of the country you might be traveling through or living in. In general, if you are spending more than 183 days (roughly half the year) in another country, you are considered to be a fiscal resident of that country. For the perpetual traveler or digital nomad who qualified under the Physical Presence Test, this is not a problem, but if you plan on taking up bona fide residency somewhere, it gets a bit tricky.
Some countries — like Costa Rica, Hong Kong, Panama, the Seychelles, Singapore and Taiwan — have a “territorial tax system,” and only tax income generated within the country’s borders. There are also a handful of countries that have no income taxation in place at all, including Andorra, the Bahamas, Bermuda, the Cayman Islands, Monaco and the United Arab Emirates.
The choice becomes whether you want to choose a country strictly for tax purposes, bite the bullet and pay tax in a country with a low income tax rate (Portugal, Bulgaria and Malta are a few of those) or choose to set up residency in a country. You can still be a permanent resident of various countries, but it depends on the local rules. In Panama, for example, you only need to be in the country for one day a year to be considered a permanent resident. Some people split time between places like Panama and Colombia, but claim residency in Panama due to the more favorable tax treatment. In any event, you should be mindful of the thresholds of becoming a tax resident. While the aforementioned 183 days is the general rule of thumb, it does not apply to every country. In these complex cases, it is prudent to receive counsel from a qualified tax attorney and CPA.
Step 5: …And Stay Out
Have a craving for Jimmy John’s? Miss the convenience of Costco? Giving in to the temptation of coming home for a taste of home may literally end up costing you thousands of dollars. Like qualifying for status on an airline or hotel chain, the rules for complying with the Physical Presence Test are very strict. To begin with, an individual must be in another country for 330 out of 365 days, though this does not have to be within a calendar year as the tax exemption can be prorated like I explained above.
This requirement is not satisfied, however, if an individual is in international waters, flying over US airspace or is otherwise in the US unexpectedly. If you are visiting the US and have to stay an extra hour because your flight is delayed or if you miss your plane because you overslept, that will count toward your allotment of days. Similarly, if you leave the West Coast at 11:00pm bound for Europe, you will be charged an additional day because you are still within the jurisdiction of the US. It is always important to leave a few buffer days, as it could be a costly mistake otherwise.
That’s It? Yes, in a (coco)nut shell, that is it. If you want the tax break, all you have to do is abandon everything you own, book a flight and never return, or at least not that much anyway. Now, the only thing left to decide is where you want to go.
Alexander Bachuwa is a New York attorney who focuses on consumer and international dispute resolution. For more information, visit his law firm’s website or his travel blog. Additional reporting by Vincenzo Villemena, an expat tax CPA based in Medellin, Colombia who travels the world advising other expats on how to optimize their tax situation.
Featured image courtesy of EyesWideOpen via Getty Images.
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