What Foreign Income Is Not Taxed in the USA?

If a person is a citizen or a legal resident of the United States of America, he or she has to pay the income tax regardless of the location where the income has been made. It does not matter if the American person has been residing and working in the U.S.A. or another country and neither does it matter when the income is made.

At the same time, there are some tax exemption opportunities in the country. Some types of foreign income can be excluded from the taxable amount. Thus, an American citizen/ resident can reduce their tax burden if they make an income in a foreign country.

US citizenship and US residency: what is the difference in terms of taxation?

The main difference between the Residency status and the Citizenship status in the U.S.A. is as follows: the former is determined by the physical presence of the person in the U.S.A. (or outside) while the latter is determined by the nationality/ citizenship of the person.

Residency status

To obtain the Residency status in the U.S.A., the person has to pass one of the following two tests:

• Green card test: the person is a legal foreign resident of the U.S.A. (a green card holder);
• Substantial presence test: the person has spent at least 31 days in the U.S.A. in the current year and at least 183 days over the last three years (certain coefficients can be applied that can change the number of days).

If the person conforms to one of these two criteria, the residency status is assigned to him/ her. Consequently, the person is taxed in the U.S.A. on the income made in any country or territory.

If the results of both tests are negative, the person is not considered a US resident. This means that he or she has to pay taxes only on the income made in the U.S.A. or from US sources (by trading with US companies or providing services to them).

Citizenship status

The Citizenship status can be obtained in the following ways in the U.S.A.:

• By birth – if the person was born in the country or at least one of his/ her parents is an American citizen;
• By naturalization – if the person has been granted American citizenship after living in the country for several years (on a green card, for example). 

Besides, the person is considered a US national if he/ she was born or has naturalized in one of the US overseas territories such as American Samoa or Northern Mariana Islands.

In all these cases, Citizenship-based taxation (CBT) is applied to the person, which means that he/ she has to pay taxes on any income that he/ she makes regardless of the person’s place of residence or the location of the income source. However, several exemptions are available that can help the person lessen his/ her tax burden a bit. These include the following ones:

• Foreign earned income exclusion (FEIE);
• Foreign housing deduction or exclusion (FHD/E);
• Foreign tax credit (FTC).

The above-mentioned exemptions are also available to legal residents of the U.S.A.

Priority of the statuses 

If you would like to understand how much you are going to have to pay in taxes in the U.S.A., you have to take the following conventions into account:

• If you are not a US citizen/ national, your Residency status will determine how much you have to pay in taxes in the U.S.A;
• If you are a US citizen/ national, your Citizenship status will be decisive as far as taxes are concerned.

Taxation in the U.S.A.: the implications of the residency and citizenship statuses

The overall amount of taxes that a legal resident and a citizen of the United States of America has to pay is basically the same: the person’s global income is taxed in both cases. However, there are some minor differences between the two statuses: some tax incentives available to US citizens are not available to legal residents of the country. For example:

• Legal residents of the U.S.A. can lose their status if they are absent from the country for a long time. Alternatively, a green card holder has the right to give it up. A US citizen has to file an official application if he/ she wants to renounce their citizenship and the procedure is going to be more complicated than the procedure of returning the green card.
• Legal residents of the U.S.A. can also be taxable in their home countries if such are the fiscal regulations applied in these countries. Dual citizenship is allowed in the U.S.A. and an American citizen can renounce his/ her foreign citizenship and thus stop paying taxes in two countries at a time. If the U.S.A. and the second country of the person’s citizenship have a treaty on double taxation avoidance, the person is not going to be taxed in two countries at a time.
• Legal residents of the U.S.A. do not have access to some tax incentives available to US citizens. For example, they are not eligible for tax deductions available to US citizens who have dependent relatives living outside the U.S.A. or residing in Canada or Mexico. (The tax deduction was suspended for US legal residents in 2018 and the suspension will remain in place until 2025.)

Foreign earned income tax exemption

Foreign earned income exclusion is an opportunity to deduct up to US$112,000 of foreign earned income from the overall tax base. The amount is indexed every year and in 2023 (tax return to be filed in 2024) the maximum exclusion amount is going to be US$120,000. Incomes can be derived from the following foreign sources:

• Salaries;
• Fees;
• Other payments for services. 

If the income has been derived from a passive source (such as dividends, interests, lease, pensions, etc.), it cannot be excluded from the overall taxable income.

To make use of the foreign earned income exclusion opportunity, you have to submit Form 2555 together with your federal tax return. Besides, you will have to satisfy one of the following criteria:

• Be a US citizen or a US legal resident who is a citizen of a foreign country that has a double taxation avoidance agreement with the U.S.A. Moreover, you have to be a ‘bona fide resident’ of a foreign country (foreign countries) over a long uninterrupted period (at least one fiscal year).
• Be a US citizen or a legal foreign resident who is away from the U.S.A. for at least 330 days within any 12-month period.

Please note that you can qualify for part of the exclusion if you have spent only part of the required period in a foreign country.

Foreign housing deduction or exclusion (FHD/E)

FHD/E allows deducting or excluding a certain amount of money from the taxable income if you have residential accommodations in a foreign country and you have to cover the maintenance costs. The following items of expenditure can be excluded from the taxable income:

• Rent pay;
• Utilities (with the exception of the telephone bills);
• Home insurance;
• Home repair;
• Personal taxes on property;
• Some other items of expenditure associated with having/ using residential accommodations in a foreign country.

The following items of expenditure cannot be excluded from the tax base: purchase or residential property, furniture, clothes, and food products.

To make use of the foreign housing deduction or exclusion opportunity, you have to submit Form 2555 together with your federal tax return. In addition to that, you have to meet the eligibility criteria for foreign earned income exclusion.

The costs associated with housing in a foreign country to be deducted from the taxable income cannot exceed the total amount of foreign earned income.

Besides, the maximum amount of expenditures associated with housing in a foreign country is limited. Normally, it cannot exceed 30% of the total foreign earned income excluded from the tax base. For example, the amount has been set at US $36,000 in 2023. The amount may be altered depending on the location of the property and the number of days per year that it has been used for living.

Foreign tax credit

The foreign tax credit refers to the amount of taxes (or equivalent charges) paid in a foreign country (minus the allowances and tax exemptions).

In certain cases, this opportunity can help you reduce the overall tax burden if you are taxed in the U.S.A. 

To be eligible for the foreign tax credit, you have to file Form 1116 together with your federal tax return. In addition to that, you will have to conform to the following criteria:

• The foreign income to be taxed shall be taxable in the U.S.A. of another jurisdiction that is under the US control;
• You have documents confirming that the taxes have been paid in a foreign country or that the taxes have been charged there;
• The foreign tax shall be obligatory; it shall be already paid or charged by the fiscal authorities of the foreign country;
• The foreign taxes shall not be returnable or reimbursable;
• The foreign taxes shall not be somebody else’s taxes but you own.

The Foreign Tax Credit amount cannot exceed the amount of income taxes payable in the United States multiplied by the share of the foreign income in the total amount of income. If you have paid some foreign taxes and have not applied for the foreign tax credit, you can do so on a later date within the next 10 years.

What other types of foreign income can be tax-exempt in the U.S.A.?

Legal residents and citizens of the U.S.A. can avoid paying taxes on the following types of foreign income:

• Income derived from sale of residential property in a foreign country on the condition that the property has been used for living for at least two years within five years prior to the sale;
• Stipends and grants for students and researchers studying/ doing research in a foreign country on the conditions that the stipends/ grants have not been used to cover the services that you have provided;
• Some types of foreign pensions and foreign social allowances of they meet certain requirements;
• Some types of income from interests or dividends in a foreign country on the condition that they are not associated with business or professional activities on the territory of the U.S.A.

Declaring foreign income in the U.S.A.

If you are a legal resident or a citizen of the United States, you have to file a tax return regardless of how much foreign income you have made over the year. The following sources of foreign earned income have to be specified in your tax return:

• Salary;
• Interests;
• Dividends;
• Rent pay;
• Pension;
• Stipend/ grant;
• Royalties;
• Other sources of income.

The income has to be declared in the national currency that it has been made in and then the amount needs to be converted to the US dollars at the rate applicable on the day of the tax return submission.

If you are a citizen or a legal resident of the United States of America and you would like to optimize your tax burden, please write to info@offshore-pro.info or contact us in any other way that you prefer. Our experts will get back to you quickly and consult you on the matter free of charge.

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• Registration of a limited liability company in the state of Florida (USA);
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