How to Avoid Double Taxation on Foreign Income While Living in the U.S.

Earning income from a foreign country while residing in the U.S. can create tax complications, particularly the risk of being taxed twice—once by the foreign country and again by the U.S. government. Fortunately, legal mechanisms exist to reduce or eliminate this burden.

Residency Classifications

The way the U.S. taxes foreign income depends on residency status. The IRS classifies individuals as either U.S. residents or nonresidents for tax purposes.

A person is generally considered a U.S. resident if they meet the substantial presence test or hold a green card. The substantial presence test applies to those who have spent at least 183 days in the U.S. over a three-year period, calculated using a weighted formula: all days in the current year, one-third of the days in the previous year, and one-sixth of the days from two years prior. Meeting this threshold requires reporting all income, regardless of where it was earned.

For those who do not meet the substantial presence test, the closer connection exception may apply. This allows individuals to avoid U.S. tax residency if they can prove stronger ties to another country, such as a permanent home, family, or business interests. Filing Form 8840 is required to claim this exception.

Excluding Wages and Housing Costs

The Foreign Earned Income Exclusion (FEIE) allows U.S. residents working abroad to exclude up to $126,500 of foreign earnings in 2024. This applies only to earned income, such as salaries and wages, and does not cover passive income like dividends or rental earnings.

To qualify, taxpayers must pass either the bona fide residence test or the physical presence test. The bona fide residence test requires proving permanent residency in a foreign country for an uninterrupted tax year, while the physical presence test mandates spending at least 330 full days outside the U.S. in a 12-month period. Those who qualify can claim the exclusion by filing Form 2555.

The Foreign Housing Exclusion or Deduction helps offset housing costs like rent, utilities, and insurance. The base housing amount is 16% of the FEIE limit, meaning only costs exceeding $20,240 in 2024 are eligible. In high-cost cities such as Hong Kong or London, the IRS provides increased limits, published annually in IRS Notice 2024-20.

Crediting Taxes Paid Abroad

When earning income in another country, individuals may be taxed by that jurisdiction before reporting the same earnings on a U.S. tax return. To prevent double taxation, the Foreign Tax Credit (FTC) allows taxpayers to offset U.S. tax liability by the amount of foreign taxes paid. This credit applies to income, war profits, and excess profits taxes imposed by a foreign government or U.S. possession.

The credit is limited to the lesser of the actual foreign taxes paid or the U.S. tax liability on the foreign income. The allowable amount is determined using the formula: (foreign taxable income ÷ total taxable income) × total U.S. tax liability. If foreign taxes exceed the U.S. liability, the excess can be carried back one year or forward up to ten years.

Not all foreign taxes qualify. Value-added taxes (VAT), sales taxes, and social security contributions are ineligible. Additionally, taxes refunded or reimbursed by a foreign government cannot be claimed. Taxpayers must maintain documentation, including foreign tax returns, withholding statements, and proof of payment, and report the credit on Form 1116 unless they qualify for the exemption allowing direct entry on Form 1040.

Treaty Arrangements

Tax treaties between the U.S. and other nations help prevent double taxation by outlining which country has the primary right to tax specific types of income. These agreements, negotiated with over 60 countries, often provide reduced withholding tax rates on dividends, interest, and royalties. For example, under the U.S.-U.K. treaty, dividends paid by a U.K. corporation to a U.S. resident may be subject to a lower withholding tax rate than the standard 20% applied to non-treaty countries.

Treaties also establish residency tie-breaker rules for individuals considered tax residents in both jurisdictions. These provisions evaluate factors such as permanent home location, center of vital interests, and habitual abode to determine which country has primary taxing rights. This is particularly useful for expatriates or dual residents facing conflicting tax obligations.

Additionally, treaties address the taxation of pensions and social security benefits, often stipulating that such income is taxable only in the country of residence. This prevents retirees receiving foreign pension distributions from being taxed twice.

Filing Requirements

U.S. taxpayers earning foreign income must comply with IRS reporting rules, including disclosing earnings, claiming available exclusions or credits, and, in some cases, reporting foreign financial accounts. Failure to meet these obligations can lead to penalties.

For those claiming the Foreign Earned Income Exclusion or Foreign Housing Exclusion, Form 2555 must be attached to their tax return. Taxpayers using the Foreign Tax Credit must file Form 1116 unless their total foreign taxes paid are below the IRS threshold for direct entry on Form 1040.

Individuals with foreign bank accounts exceeding $10,000 at any point during the year must submit a Foreign Bank Account Report (FBAR) via FinCEN Form 114, separate from their tax return.