Taxpat's US Tax Blog

Introducing CLVN's US Tax Blog

As of December 2009, David Colvin no longer works at Taxpat.  He has launched a new blog, CLVN's US Tax Blog.  The Taxpat team will be maintaining the Taxpat blog.

Taxpat

Seven Important Points About Penalties

The following is a nice summary of the Failure-to-File and Failure-to-Pay Penalties that the IRS imposes.  Note that for US expats, neither of these penalties apply until after June 15, as long as you attach a statement to your tax return explaining that you were residing abroad on April 15.

IRS Tax Tip 2009-51 (http://www.irs.gov/newsroom/article/0,,id=205326,00.html)

Taxpayers who do not file their return and pay their tax by the due date may have to pay a penalty. Here are seven things you should know about failure-to-file and failure-to-pay penalties.

1. The failure-to-file penalty is generally more than the failure-to-pay penalty. So if you cannot pay all the taxes you owe, you should still file your tax return and explore other payment options in the meantime.
   
2. The penalty for filing late is usually 5 percent of the unpaid taxes for each month of part of a month that a return is late. This penalty will not exceed 25 percent of the taxpayer’s unpaid taxes.
   
3. If you file your return more than 60 days after the due date or extended due date, the minimum penalty is the smaller of $135 or 100 percent of the unpaid tax.
   
4. You will not have to pay a failure-to-file penalty if you can show that you failed to file on time because of reasonable cause and not because of willful neglect.
   
5. You will have to pay a failure-to-pay penalty of ½ of 1 percent of your unpaid taxes for each month or part of a month after the due date that the taxes are not paid.
   
6. If you filed an extension and you paid at least 90 percent of your actual tax liability by the due date, you will not be faced with a failure-to-pay penalty.
   
7. If both the failure-to-file penalty and the failure-to-pay penalty apply in any month, the 5 percent failure-to-file penalty is reduced by the failure-to-pay penalty. However, if you file your return more than 60 days after the due date or extended due date, the minimum penalty is the smaller of $135 or 100% of the unpaid tax.

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998.  His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues.  He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.

Fines for (NL Residents with) Secret Bank Accounts to Triple

Scary news for those taxpayers still not reporting their worldwide assets in Box 3. If you are ready to come clean and want to take advantage of the amnesty program, there is a specific form to complete, called a "Vrijwillige Verbetering", which can be downloaded from the Belastingdienst web site at http://download.belastingdienst.nl/belastingdienst/docs/vrijwillige_verbetering_buitenlands_vermogen_ib151z3plfol.pdf.
Unfortunately the form seems to be available only in Dutch.  Note that tax paid in Box 3 is a "creditable" tax for US tax purposes, so playing it by the book usually doesn't give too bad of a result for US citizens, aside from avoiding penalties down the road.

Per DutchNews.nl (www.dutchnews.nl), Monday 06 April 2009:

The fine for people found to have secret bank accounts abroad is to be tripled to 300% of the non-declared savings, tax minister Jan Kees de Jager told tv show Buitenhof on Sunday.

At the moment, people found with secret savings face having all of the money confiscated by the tax authorities. If MPs back de Jager's proposals, they will also have to pay the same amount twice over in fines.

Since 2002, the government has operated an amnesty for people with secret accounts. If they admit to having money stashed abroad they have to pay an extra tax surcharge but no fine and will not face criminal prosecution.

So far this year 317 people have come forward, admitting to secret savings totalling some €70m.

Drug dealers

The Telegraaf reports on Monday that a considerable percentage of the people declaring their foreign savings are soft drugs traders who made their money in the 1990s.

'If they declare their money to the tax before an investigation is begun, they do not have to say where their capital came from,' one lawyer told the paper.

Since it emerged that Switzerland, Liechtenstein, Luxemburg and Andorra are reforming their bank secrecy laws, the number of people declaring their foreign accounts has gone up by 20 a day, the paper says.

Tax havens are coming under increasing pressure on their banking secrecy laws and world leaders agreed at last week's G20 summit in London to take tougher action against them.

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998.  His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues.  He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.

How Do You Qualify for the Foreign Earned Income Exclusion?

United States citizens and resident aliens are taxed on their worldwide income, whether the person lives inside or outside of the United States. However, qualifying U.S. citizens and resident aliens who live and work abroad may be able to exclude from their income all or part of their foreign salary or wages, or amounts received as compensation for their personal services. In addition, they may also qualify to exclude or deduct certain foreign housing costs.

A common misconception that contributes to the international tax gap is that this potentially excludable foreign earned income is exempt income not reportable on a US tax return. In fact, only a qualifying individual with qualifying income may elect to exclude foreign earned income and this exclusion applies only if a tax return is filed and the income is reported.

General Rule

To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must:

• Have foreign earned income (income received for working in a foreign country),
• Have a tax home in a foreign country, and
• Meet either the bona fide residence test or the physical presence test

Exclusion Amounts and Limits

The foreign earned income exclusion amount is adjusted annually for inflation, starting with the 2006 tax year. For 2008, the maximum foreign earned income exclusion is up to $87,600 per qualifying person. If married and both individuals work abroad and both meet either the bona fide residence test or the physical presence test, each one can choose the foreign earned income exclusion. Together, they can exclude as much as $175,200 for the 2008 tax year.

In addition to the foreign earned income exclusion, qualifying individuals may also choose to exclude or deduct from their foreign earned income a foreign housing amount. Starting with the 2006 tax year, the amount of qualified housing expenses eligible for the housing exclusion and housing deduction is limited. The limitation on housing expenses is generally 30% of the maximum foreign earned income exclusion. For 2008, the housing amount limitation is $26,280 for the tax year. However, the limit will vary depending upon the location of the qualifying individual’s foreign tax home and the number of qualifying days in the tax year.

The foreign earned income exclusion is limited to the actual foreign earned income minus the foreign housing exclusion. Therefore, to exclude a foreign housing amount, the qualifying individual must first figure the foreign housing exclusion before determining the amount for the foreign earned income exclusion.

How to Claim the Exclusion

Since the foreign earned income exclusion is voluntary, qualifying individuals must choose to claim the exclusion. The foreign earned income exclusion and the foreign housing cost amount exclusion are claimed and figured using Form 2555 (pdf), which must be attached to Form 1040 (pdf). However, if only the foreign earned income exclusion is claimed, a shorter Form 2555-EZ (pdf) may be used instead.  Once the choice is made to exclude foreign earned income, that choice remains in effect for the year the election is made and all later years, unless revoked.

Other Rules

Not foreign earned income: Foreign earned income does not include the following amounts:

• Pay received as a military or civilian employee of the U.S. Government or any of its agencies
• Pay for services conducted in international waters (not a foreign country)
• Pay in specific combat zones, as designated by an Executive Order from the President, that is excludable from income
• Payments received after the end of the tax year following the year in which the services that earned the income were performed
• The value of meals and lodging that are excluded from income because it was furnished for the convenience of the employer
• Pension or annuity payments, including social security benefits

Self-employment income: A qualifying individual may claim the foreign earned income exclusion on foreign earned self-employment income.  The excluded amount will reduce the individual’s regular income tax, but will not reduce the individual’s self-employment tax.  Also, the foreign housing deduction – instead of a foreign housing exclusion – may be claimed.

Figuring the tax: Beginning with tax year 2006, a qualifying individual claiming the foreign earned income exclusion, the housing exclusion, or both, must figure the tax on the remaining non-excluded income using the tax rates that would have applied had the individual not claimed the exclusions.

Foreign tax credit or deduction: Once the foreign earned income exclusion is chosen, a foreign tax credit, or deduction for taxes, cannot be claimed on the income that can be excluded.  If a foreign tax credit or tax deduction is claimed for any of the foreign taxes on the excluded income, the foreign earned income exclusion may be considered revoked.

Earned income credit: Once the foreign earned income exclusion is claimed, the earned income credit cannot be claimed for that year.

Timing of election: Generally, a qualifying individual’s initial choice of the foreign earned income exclusion must be made with one of the following income tax returns:

• A return filed by the due date (including any extensions),
• A return amending a timely-filed return.  Amended returns generally must be filed by the later of 3 years after the filing date of the original return or 2 years after the tax is paid, or
• A return filed within 1 year from the original due date of the return (determined without regard to any extensions)

Revoking the exclusion: A qualifying individual can revoke an election to claim the foreign earned income exclusion for any year.  This is done by attaching a statement to the tax return revoking one or more previously made choices.  The statement must specify which choice(s) are being revoked, as the election to exclude foreign earned income and the election to exclude foreign housing amounts must be revoked separately.  If an election is revoked, and within 5 years the qualifying individual wishes to again choose the same exclusion, the individual must apply for approval by requesting a ruling from the IRS.

Source:  www.irs.gov

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998. His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues. He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.

Is a Foreign Mortgage Worth the Risk?

Anyone who has asked me knows I am no fan of investing in real estate in (Western) Europe at the moment.  One of the biggest risks I see (aside from the fact that real estate prices have not "corrected" yet in many cities) is a little-known IRS law concerning taking out a mortgage in foreign currency. 

Sec. 985(a) of the Internal Revenue Code generally requires all income tax determinations to be made in the taxpayer's "Functional Currency", which for US citizens and greencard holders is always the USD, regardless of where they reside or how they are paid.  Sec. 988 of the Code covers "988 transaction", which includes the acquisition of debt in a non-functional currency such as becoming an obligor under a mortgage, and requires you to use your functional currency when determining a gain or loss on the mortgage. 

What does this actually mean for you?  It means that you need to convert the amount of the loan into USD at the time you borrow the money and again at the time you pay off the loan.  If there is a gain, this is taxable as ordinary income (not capital gain and not eligible for the $250K/$500K exclusion under IRC Sec. 121).  If you have a loss, this is considered a "personal", non-deductible loss (so basically the IRS gets the upside but not the downside).

This hasn't been much of an issue for the past several years, because the weakening dollar has created losses, which are not deductible.  Also, most taxpayers didn't even know they had a loss (because this law is pretty obscure) so they didn't feel like they missed out.  In addition, rising home prices have created gains (in both Euro and dollar terms) on most sales, so everyone's happy. 

So why is this a dangerous time to take out a foreign mortgage?  I can't predict the future, but my money is on the dollar strengthening over the next few years.  If this happens, you will start to see the ugly side of this law.  For example, if you borrowed EUR 1M today, you would be borrowing approx. $1,550,000.  Now assume you pay off this mortgage 10 years from now, and the dollar has strengthened significantly, back to 1:1 with the Euro (hey, it could happen!).  This means you only need to pay back $1,000,000 (in the eyes of the IRS).  In this case you have a $550,000 gain from paying off your foreign mortgage, taxable as ordinary income, so as high as 35% (or whatever higher rate may be in place at the time).  This means a potential tax of almost $200K, even if you actually lost money on the home sale, which I think is a "real" risk at the moment. 

Sound too bad to be true?  These rules are clearly laid out in Rev. Ruling 90-79, 1990-2 CB 187, and also in the 1996 court case "Quijano v. the United States" (96-2 USTC P 50,441), and don't leave much room for interpretation.

I'm not a fan of letting taxes rule your "life" decisions, but this one is definitely something to take into account if you are currently considering buying a property in Europe and don't have the cash to purchase without a mortgage.

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998.  His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues.  He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.

How is the Sale of a Foreign Personal Residence Taxed in the US?

One of the most common issues I see (and probably the one with the most impact) is the taxation on the sale of a foreign personal residence. 

US citizens (and greencard holders) are required to use the US Dollar as their "functional currency" for all "personal" transactions, including the purchase and sale of a foreign residence.  For most US expats, there are actually two separate taxable transactions that occur when you sell a foreign residence - "Capital Gain" from selling the residence, and "Exchange Rate Gain" from paying off a mortgage denominated in a foreign currency.

Taxation of Capital Gain:

The current tax rate on the gain from selling a personal residence is 15% (as long as you have held the property for at least a year).  The gain is calculated by translating the purchase price using the exchange rate at the time of the purchase, the cost of capital improvements using the exchange rate at the time the improvements were made and the exchange rate at the time of the sale, rather than by using the exchange rates at the time of sale in all three cases (C.J. Quijano v. US; 96-2 USTC P 50,441).  If you meet the requirements of IRC Sec. 121 (you owned and used the property for 2 of the 5 years prior to the sale or meet one of the exceptions), you are allowed to use the $250,000 ($500,000 if MFJ) exclusion available to properties located in the US.  If the result is a capital loss, this is considered a personal, non-deductible loss.

Taxation of Exchange Rate Gain:

The Exchange Rate Gain from paying off a mortgage denominated in a foreign currency is treated a separate transaction and is calculated by translating the amount of the loan using the exchange rate at the time the loan was originated and the exchange rate at the time of the loan was paid off.  The resulting "gain" is taxable as "ordinary income" using your marginal tax rate (maximum 35% for 2008).  Again, if the result is a capital loss, this is considered a personal, non-deductible loss.

Note that you cannot use the loss from the mortgage payoff (which is what most people have these days) to offset the capital gain from the sale of the home (Revenue Ruling 90-79, 1990-2 CB 187).

These rules may look harmless enough, but the results can be devastating and should be taken into account if you are considering selling (or before buying) a foreign residence. 

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998.  His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues.  He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.

Should you "revoke" the Foreign Earned Income Exclusion?

Based on the current US tax laws for expats, many taxpayers (mainly those in high tax countries) may be better off if they "revoke" one of the main benefits for expats, the Foreign Earned Income and Housing Exclusions.

Some background - the Foreign Earned Income and Housing Exclusions are not "optional".  If you don't want to claim the Foreign Earned Income and/or Housing Exclusions (after you have once claimed them on a prior tax return), you need to "revoke" them by attaching a statement to your tax return (see IRC Sec. 911(e)(2) for those of you who like to read the Internal Revenue Code).

Why the change now?  The Tax Increase Prevention and Reconciliation Act of 2005 (ironically) changed (by increasing) the way expats calculate the US tax on "non-excluded" income.  Prior to the 2006 tax year, expats would deduct the exclusions and then calculate the tax on the remaining income, so you got to use the lowest marginal tax rates.  As of 2006, you need to add back the exclusions before calculating tax, which means you generally "start" at a much higher marginal tax rate (the IRS calls this the "stacking rule"). 

Since Foreign Tax Credits are calculated based on average tax rates, but the income gets taxed at the higher "marginal" tax rates, you "lose out" when calculating you foreign tax credits  if you use the exclusion (and have sufficient foreign tax credits).

For example, a taxpayer in the Netherlands (without the 30% ruling) earning $200K might pay $75K in Dutch income tax.  If they use the exclusion, their US tax would be (roughly) based on $200K - $80K = $120K (less deductions and exemptions).  Let's say the "marginal" US tax rate is 30%, or $36K of tax before credits.  The tax after credits would be zero and the Foreign Tax Credit Carryover would be $9K ($75K Dutch tax paid less $30K allocated to excluded income less $36K used as a Foreign Tax Credit).

If the taxpayer did not claim the exclusion, the Dutch tax would remain the same, but the US tax would be based on $200K.  In this case the "average" tax rate might be (again very roughly) around 25%, or $50K (this is lower than the first example because you get to use the lower tax brackets to calculate the average rate).  After applying Foreign Tax Credits, the US tax would still be zero, but the Foreign Tax Credit Carryover would now be $25K ($75K less the $50K used as a Foreign Tax Credit).

Since "excess" tax credits carry over for 10 years, the taxpayer would be leaving $16K "on the table" by taking the exclusion (since the tax due in both cases is zero, but the carryover with the exclusion was $9K and without it was $25K).  In the event the taxpayer then moved back to the US (and continued to have foreign travel days), or to a no tax country such as Dubai, or a very low tax country such as many in Asia, they may have missed out on a huge benefit by unnecessarily using foreign tax credits. 

Sound complicated?  It is.  It turns out this decision is very complex for many taxpayers, not least because you need to know what you are doing for the next several years, because if you do choose to revoke the exclusion, you cannot claim it again until the sixth taxable year after the exclusion was revoked. 

Note:  If you have the "30% ruling" in the Netherlands, it probably doesn't make sense to revoke, but it doesn't hurt to do a quick analysis just in case (we currently do this analysis for all of our clients).

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998. His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues. He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.

What is the US Tax Return Due Date for Expats?

The initial due date for filing your US tax return for all US citizens, greencard holder and other residents is April 15, regardless of where you reside. 

There is a common misconception that the due date is June 15 for expats.  This is partially true - if you are living outside of the US on April 15, you have an "automatic extension" to June 15 for filing your US tax return.  This automatic extension means you can temporarily avoid both the late filing and the late payment penalties (but not interest) even if you do not file an extension.  However, if you take advantage of the automatic extension, it is important that you attach a statement to your tax return explaining that you have done so.  Note that the automatic extension may not be valid for your state tax return, if applicable.

If you need additional time (i.e. you cannot file by June 15), you need to file Form 4868 by June 15 (www.irs.gov/pub/irs-pdf/f4868.pdf).  There is a box to tick on this form when you were living outside of the US on April 15.  This form gives you until October 15 to file your tax return. 

As an expatriate, you can even get an additional extension until December 15.  There is no special form for this (in the past you used the now-obsolete Form 2688).  In order to obtain the additional two month extension you need to write a letter to the IRS explaining your situation and why you need the additional two months.  If they approve your letter, you won't hear anything.  It is a good idea to send this letter by registered mail or courier so that you can show proof of mailing if necessary.

Finally, in case this wasn't all confusing enough, there is a special extension possible for expatriates who moved out of the US during the tax year and require additional time to qualify for the "Foreign Earned Income Exclusion" using either the "Bona Fide Residence Test" or the "Physical Presence Test".  You apply for this extension using Form 2350 (www.irs.gov/pub/irs-pdf/f2350.pdf).  With this form, you are able to request an extension until 30 days after you qualify for the Foreign Earned Income Exclusion.  If you are using the Bona Fide Residence Test, this means you have until January 30 of the following year (e.g. for 2007 tax return, you get an extension to January 30, 2009).

Additional information can be found in Publication 54, Tax Guide for US Citizens and Resident Aliens Abroad (www.irs.gov/pub/irs-pdf/p54.pdf).

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998. His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues. He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.

US Citizens Get an Additional Benefit Under the 30% Ruling

The 30% ruling is intended to attract skilled individuals to the Netherlands, and indeed is the reason many US citizens choose to move to the Netherlands, since it (effectively) means the top tax rate is 36.4% (vs. 52% without the 30% ruling). 

Many US expats (and their tax advisors) are not aware that US citizens have an additional benefit that is not available to other countries' citizens - the "foreign days exclusion".  US citizens (or green card holders) with the 30% ruling are only required to pay tax on days worked in the Netherlands.  What this means is that you do not pay Dutch tax on days worked outside of the Netherlands.  This can be a huge benefit for individuals who travel a lot for work. 

For example, if your salary is EUR 157,143 per year you would initially get 30% of this amount tax free, leaving a taxable salary (for Dutch tax purposes) of EUR 110,000.  Assuming you worked 220 total days in the year, this translates to EUR 500 per day of work.  Since the "marginal" tax rate is 52% on this level of income, the benefit of each day worked outside of the Netherlands is 52% * EUR 500, or EUR 260/day.  So that week you spent working in London would add EUR 1,300 to your pocket at tax time.  Not bad!

Note that US citizens (and greencard holders) are still subject to US tax on their "worldwide" income, so you may shift some of the tax burden to the US (this is the reason that the Netherlands allows a reduction for workdays outside of the Netherlands, it has to do with a special clause in the US-NL treaty).  But shifting income out of a 52% tax bracket will always work out to your benefit.

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998. His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues. He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.

I've worked in both the US & the Netherlands - Where am I eligible for social security?

Social security is a pretty confusing issue.  We don't know if we will get anything at all, and working in multiple countries compounds the confusion.  The general principle is that you get paid by the countries where you have paid in social security taxes.  However, there is usually a minimum amount of time that you need to work in order to be eligible.  For example, in the US you need "40 quarters" (effectively 10 years) in order to qualify at all.

Luckily, the US and the Netherlands (and many other countries) have what is called a "Totalization Agreement", which allows you to use the time working in the Netherlands to qualify for the 10 year minimum.  For example, if you worked 6 years in the US and 4 in the Netherlands, you would qualify for US social security even though you did not work 10 years in the US.  Or what I see more commonly (with US expats), if you only live in the Netherlands for a few years, you can still qualify for Dutch social security when you retire.  However, if you don't meet the minimum guidelines, you need to inform the appropriate agencies (normally by writing a letter) and get proof from the other country of the "qualifying" years in that country.  You also need to make sure they have your current address when you retire.

Before you go planning your dream vacations in your retirement, keep in mind that the actual benefit you get is still based on the time you worked in each specific country.  In the example above, the person would have 6 years of credit in the US.  The benefit payment is based on your highest 35 years of income in the US, so the benefit would be based on 6/35 of the "full" benefit (or about $375/mo based on the current maximum of approx. $2,185/mo).  See also the Social Security web site (www.ssa.gov).

In the Netherlands they have a similar system, but it is based on 50 years of living in The Netherlands (not necessarily working), so in the example above the person would get 6/50 of the maximum benefit.  That would be enough to buy yourself a koffie verkeerd and a warme appeltaart (with slagroom)!

Please note that the actual calculation of benefits is a bit more complex than this, but this gives you the general idea. 

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998. His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues. He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.