There are many good reasons for moving abroad, among them, the possibility of better weather, a lower cost of living, access to higher quality, lower cost healthcare and an improved lifestyle. However, another less well-known but significant reason more Americans are choosing to live abroad is to lower their U.S. income taxes, many times to zero.
The way they do this is by using the Foreign Earned Income Exclusion, which allows them to exclude up to $100,800 from their U.S. taxable income in 2015. If the law doesn't change (and it has been in place for many years), they will be able to exclude even more in 2016.
To explain how the Foreign Earned Income Exclusion works, Best Places in the World to Retire interviewed three specialists in this area, Don Nelson,a U.S. Tax Attorney and retired CPA with over 35 years experience specializing in U.S. international, expatriate and nonresident taxation, David McKeegan, founder of a business with 38 accountants and a staff of seven serving clients in over 150 countries, and Stewart Patton, founder of U.S. Tax Services, and a U.S. tax attorney now living in Belize.
We used a fictional U.S. taxpayer named George to illustrate certain points. Nelson, McKeegan and Patton stressed that they were providing only general information and examples. They said that everyone's tax situation is different, and before using the Foreign Earned Tax Exclusion or any tax strategy when filing in an overseas jurisdiction, to obtain the counsel of a qualified professional.
McKeegan said that most expats use the Physical Presence Test, as it's the "most straight-forward" way to qualify, and that to qualify, George would have to be physically outside the U.S. for 330 days in a 365-day period.
The Bonafide Residency Test contains more areas for interpretation, Nelson said, and that to qualify under this test, "George would have to demonstrate that he was moving abroad as a full-time resident, and that he would be there for a while."
Nelson said that many expats like George effectively doubled the value of the Exclusion because their spouse could qualify independently. "Lots of married expats do exactly this while both working for the same company, or even different companies," Nelson said.
Nelson said that George could only apply the Earned Income Exclusion to earned income, but not to rent, dividends, interest and capital gains. He said that the good news is that "George can still take his other deductions and exclusions, and, in certain circumstances, George could even prorate his exclusion."
However, just because George may qualify for the Foreign Earned Income Exclusion for U.S. income taxes doesn't mean that he automatically pays zero taxes in his expat home.
Patton said that the easiest and most obvious way for George to avoid foreign income taxes would be to live in a jurisdiction that has a zero tax rate.
There are several jurisdictions with zero income tax rates, including the Bahamas, Bermuda, and the British Virgin Islands. "If George lives in any of these places and qualifies for the Foreign Earned Income Exclusion," said Patton, "he really does have a zero tax rate on his first $100,800 of income."
Patton explained that are other ways for George to avoid paying any income taxes to a foreign country that otherwise would tax income, including George not spending any more than 180 days in a single country over a year. "While the laws of each country are different and subject to change, for many countries, George would be considered a tax resident only if he spends more than 180 days in any year in that country," he said. "If George isn't considered a tax resident, he is not subject to paying taxes in that jurisdiction."
Patton said that many Digital Nomads have a lifestyle consistent with not becoming a tax resident in any one country. "George may spend four months in Panama, the next four months in Mexico, and then drive across the border and top it off with 4 months in Belize."
What if George doesn't want to (or can't) live in a zero tax rate jurisdiction or move from place to place to avoid becoming a tax resident of any one country?
Patton said that George could still reduce or eliminate his non-U.S. tax liability by living in a country that uses the territorial tax system, which taxes income based on where the income is sourced. In this example, if George receives his paychecks from the U.S., he may not owe income tax to the country in which he resides.
Countries that use the territorial tax system include Costa Rica, Hong Kong, Panama and the Philippines. "Under the territorial tax system," Patton says, "only income that George generates from the country in which he lives is subject to tax. For example, if George lives in Panama and earns $100,000 worldwide but generates zero income from Panama, he owes zero income tax to Panama."