THE DIGITAL NOMAD TAX GUIDE
An Introduction
First of all, obligatory legal disclaimer. I must make it clear that I am not your attorney. The rules outlined below apply differently to everyone based on each individuals’ facts and circumstances. This is not legal advice, etc.
My goal in writing this guide is to provide general information to make you a more well-informed tax payer and to also provide practical tips you can follow to ensure compliance with tax law and possibly help save you tax dollars. With that said, this guide does cover some pretty complex topics. I have included rules from regulations that even most tax lawyers likely would not discover unless doing targeted research for a digital nomad client.
A few years ago I begin writing what would have been my first book all about digital nomad taxes. It never happened - I instead wrote Unf*ck Your Biz - but I decided to turn what I had completed into a blog. Since there was so much juicy, riveting content already, I split it into 5 parts. I'd recommend reading them in order, like chapters in a book. However, if you want to skip ahead you'll find direct links to the other parts below.
The General Rule
The U.S. tax system is widely considered one of the most complex in the world. Unsurprisingly, U.S. international tax law is one of the more complicated areas of U.S. tax. There are different rules that apply to citizens vs. non-citizen residents vs. non-residents. This guide is focused on the rules affecting U.S. citizens living and working abroad. For tax purposes, under most rules, Green Card holders are treated as U.S. citizens, so this guide should prove useful for these individuals as well.
The general rule regarding U.S. tax is that U.S. citizens are taxed on their worldwide income. Throughout this series, this principle will be referred to as the “General Rule.” Let’s state it one more time. The General Rule is that, U.S. citizens are taxed on their worldwide income.
The vast majority of nations only tax citizens on income earned in that respective country. Our tax code makes things a little trickier. This means that a U.S. person living the entire tax year in a foreign country is still subject to U.S. tax. There are many exceptions to the General Rule, but it’s important to understand our baseline. It’s provide the why behind why we need to pay such close attention to the rules.
Tax Lingo
Before diving into the rules, it’s helpful to understand some tax industry specific terms, which may have different definitions outside of the tax context.
Income Tax
The majority of people are most familiar with income tax. The tax brackets you have seen are for income taxes where the higher your income, the higher your tax bracket. Other taxes include sales tax, property tax, and gift and estate tax.
Self-Employment Tax
U.S. individual taxpayers pay an additional tax to fund Medicare and Social Security. The tax for both totals 15.3% of your income (up to certain thresholds). Typically, as a wage employee, the taxpayer pays half of that amount and the employer pays the other half. However, self-employed individuals must pay the full 15.3% on their own. This is called self-employment tax, which is in addition to any income tax you may owe. SE tax is typically due on earned income. S Corps help us save some SE taxes. We also won’t typically owe this tax on investments income and other sources of income.
U.S. Person
The General Rule applies to U.S. persons. Thus, as a threshold issue, you must know if you are deemed a U.S. in order to determine if you will be subject to tax on your worldwide income. The IRS considers the following persons/entitles to be “U.S. persons” for tax purposes:
A citizen or resident (see resident defined below) of the United States;
A domestic partnership;
A domestic corporation; and
There are specific rules for trusts and estates. This guide will not cover those.
Foreign Person
The IRS classifies individuals into three categories:
Citizens,
Resident aliens, and
Non-resident aliens.
Non-resident aliens are not “U.S. persons,” so the General Rule does not applies to this group of persons. However, resident aliens ARE “U.S. persons” and are subject to most of the same rules as U.S. citizens. A non-citizen is a resident alien – meaning that she is subject to tax on her worldwide income – if she meets either the Green Card test or the Substantial Presence Test. I’ll provide these rules later in the guide.
Resident
The IRS classifies individuals into three categories:
Citizens,
Resident aliens, and
Non-resident aliens.
Non-resident aliens are not “U.S. persons,” so the General Rule does not applies to this group of persons. However, resident aliens ARE “U.S. persons” and are subject to most of the same rules as U.S. citizens. A non-citizen is a resident alien – meaning that she is subject to tax on her worldwide income – if she meets either the Green Card test or the Substantial Presence Test. I’ll provide these rules later in the guide.
Domestic vs. Foreign Business
A corporation is a domestic corporation if it was formed under U.S. law. If an owner files Articles of Incorporation in any of the 50 states, that corporation is domestic. If not, it’s foreign. A domestic partnership is any entity with at least two members that is not a corporation that was formed in the U.S.
Service Provider
As a solo-attorney I am technically both a service provider and a business operator. However, for purposes of this guide, we differentiate between these two categories of individuals. Service providers are those whose business serves clients by providing knowledge and expertise rather than a good. Examples include lawyers, accountants, designers, copywriters, and consultants. For lack of a better term, I will refer to everyone else as business operators. These people run businesses that can operate without them present. Consider a restaurant owner. The restaurant operates even while the owner is at home or traveling the globe.
Business Deductions
Deductions reduce income. A business deduction directly reduces business income. Assume a taxpayer owns a small business and has $50,000 in business income. The taxpayer pays $500 per month in business rent. That rent is a business deduction that reduces the taxpayer’s business income. $50,000 in income less $6,000 in total rent equals $46,000.
If the taxpayer in the example above also had a part time job where she made $16,000 during the year, her total income would be $46,000 (the net from her business) plus the $16,000 totaling $62,000.
If you would like more specifics on available small business deductions, check out this blog.
Standard vs. Itemized Deductions
The tax laws also allow taxpayers a number of other deductions that are not specific for business owners. Items like the charitable and mortgage interest deductions are a couple of examples.
Tracking and adding up these deductions can be a bit onerous. Presumably, for this reason, and to give a slight break to taxpayers, the tax code has what is called a “standard deduction.” The standard deduction is a specified amount by which every tax payer may reduce their income. The 2018 standard deduction for single filers is $12,000 and for married individuals filing jointly, the standard is $24,000.
Taxpayers have the choice to either take the specified standard deduction or to itemize their non-business-related deductions and take that alternative. This is what people refer to when they say “I itemized last year.” The most common itemized deductions are the mortgage interest deduction, medical expense deduction, and charitable deduction.
Typically, you would only want to itemize if your itemized deductions total more than your standard deduction. I speak with several people each tax season who have a question something like “I donated $500. Why does that donation not increase my refund?” If that donation were their only itemized deduction, then their tax filing software is likely automatically giving them the standard deduction which would provide a much better benefit.
Let’s go back to our hypothetical taxpayer. After business income, business deductions, and wage income, the taxpayer’s total taxable income is $62,000. If the taxpayer had minimal itemized deductions, she would take her standard deduction of $12,000 which would then reduce her taxable income to $50,000.
Credits
Unlike deductions which reduce income, credits may result in a dollar-for-dollar reduction in tax. Our hypnotical taxpayer has $50,000 in taxable income after applying her standard deduction. After reaching the $50,000 number, she would apply the tax brackets to actually determine her tax liability. Let’s assume she owes $5,000 tax on that income. If she had a $1,000 credit, the credit would reduce her tax from $5,000 to $4,000.
Here is another, more simplified example. Assume a flat tax of 10%. Taxpayer B has income of $55,000. In scenario 1, taxpayer B has $5,000 deduction. The deduction reduces taxable income to $50,000. 10% on that taxable income equals $5,000.
Now, in scenario B, taxpayer instead has a $5,000 credit, so taxable income remains $55,000. 10% of $55,000 is $5,500. The credit reduces the tax by $5,000, so now the taxpayer in scenario B only owes $500 in tax.
Filing Requirements
Determining whether a taxpayer is required to file a tax return is a threshold issue. Many nomads falsely believe that they need not file a U.S. tax return if they are abroad for most or all of the tax year. Unfortunately, this is incorrect.
The General Rule requires taxpayers who meet the IRS filing requirement income thresholds to file regardless of how much time they spend in the U.S. For the 2018 tax year, the filing requirement is based solely on the standard deduction. If the taxpayers income is greater than the standard deduction, she is required to file a tax return. The below chart shows the standard deductions for the 2018 tax year. (These amounts change each year with inflation. Do a quick Google to find the current amounts).
Married Filing Joint
$24,000
Head of Household
$18,000
Single OR Married Filing Separate
$12,000
For self-employed taxpayers this is based on gross, not net, income.
This makes sense because if a single taxpayer only has $10,000 in income, the deduction will reduce income to $0. Therefore, tax would be $0 UNLESS, one of the following applies:
You had net earnings from self-employment of at least $400;
You owe any special taxes including: alternative minimum tax, additional tax on a “qualified plan,” social security or Medicare on tips not reported to an employer, household employment taxes, and recapture taxes;
You or your spouse receives health savings account distributions Archer MSA, or Medicare Advantage MSA distributions;
You had wages from church or qualified church controlled organization;
You had advanced payments of the premium tax credit or health coverage tax credit.
Even when a taxpayer is not required to file, it is still generally a good practice. Particularly if a taxpayer is owed a refund due to tax withholdings or an available credit. Filing a return also starts the clock on the IRS’ allowable time to go back and audit the return, and filing a return is necessary for deductions and credits that get carried forward.
Perhaps most importantly, filing returns help tax agencies keep tabs on what taxpayers are doing from year-to-year.
Foreign Earned Income Exclusion
The FEIE is the major exception (kind of) to the General Rule. The FEIE comes from Section 911 of the U.S. tax code. It allows a person to exclude income earned abroad from their taxable income – for income tax purposes if the person qualifies. Tax payers MUST file a tax return to claim this exclusion.
The FEIE only excludes earned income, like your self-employment income. It does not exclude passive income like capital gains. It also only excludes foreign income, as is probably obvious from the title. Income earned within the U.S. cannot be excluded. Combining these two requirements means that only income earned through your efforts while outside of the U.S. is excludable. The FEIE only exempts income for income tax purposes. Taxpayers must still pay self-employment tax on their self-employment income.
Let’s look at a hypothetical. Jill lived in the U.S. January through March of 2022 and in Germany for the remainder of the year. She earned $12,000 in passive income and $120,000 in earned income. Let’s assume for simplicity that she earned the same amount each months, so these totals are cleanly divisible by 12. How much does Jill have in foreign earned income?
The passive income is not earned. We can disregard that. Jill had $120,000 in earned income, 75% of which was earned while living abroad. Thus, her foreign earned income was $90,000.
In addition to the above two caveats, the FEIE has income limitations. The exclusion is limited to $112,000 per person (in 2022). Any foreign earned income over $112,000 cannot be excluded.
Also note that any of these rules are subject to change. Many tax experts expected drastic changes to the FEIE under the 2018 tax overhaul. Luckily for expats and nomads, the FEIE provisions were largely untouched. Whenever there are whispers of tax law changes in Congress, take note and stay up on what could be changing.
Do Nomads Typically Qualify – The VERY Short Answer
Most Nomads will qualify for the exclusion if they are outside of the U.S. for at least 330 days.
Example of How the FEIE Works to Reduce Income
Let’s say Dora Designer is a U.S. citizen. Dora works at her full-time job for the month of January. Then, she leaves the county and works remotely while traveling the globe. She makes $5,000 in January and $50,000 the rest of the year. Dora’s tax return will show $55,000 of income. She will then complete the FEIE required form to exclude $50,000 of income since it was foreign earned income. The return will then show $5,000 of taxable income.
Dora could not simply report $5,000 of income since she has the burden of reporting all income and then showing why some should be excluded from tax. If Dora took the approach of only showing $5,000 of income, she may wind up in a stressful audit.
The FEIE Baseline Rule
To be eligible to claim a foreign earned income exclusion, a taxpayer must have:
A foreign tax home; and
Either
Be a bona fide resident of a foreign country
Being present in a foreign country for 330 days in 12 months
Now Let’s dive into each of these sub-rules.
Foreign Tax Home
A person’s tax home is his regular or principal place of business. If the individual has no regular or principal place of business due to the nature of the business, that person’s tax home is his “regular place of abode.” The issue with digital nomads is that, by definition and in practice, they have no regular place of abode. One court case found that where an individual has no regular place of business or abode, therefore, having no tax home, that individual is an itinerant whose tax home moves with him from place to place. This is good news for purposes of the FEIE, but not so much for purposes of traveling deductions (discussed further below).
A person does not have a foreign tax home if his abode is in the United States. Determining where one’s abode is, unfortunately, is not so simple. The tax code does not define abode, so courts have looked at different facts to determine where one’s abode is. One case interestingly cites a report from the House Ways and Means Committee to determine the legislative intent of this rule. That report stated that a person in Detroit, Michigan who commutes daily to work in Windsor, Ontario would technically have a tax home in Canada since her principal place of business is in Canada. However, her abode would be in Michigan. The law, specifically the abode rule, disqualifies her from having a foreign tax home. The case continues to state the intent seems to be clear that the abode limitation serves to provide tax benefits only to those who actually incur increased living expenses living abroad. This does not mean that you need live in a country with a higher cost of living.
The landmark cases that determined the taxpayers abode to be in the U.S. involved individuals who worked on oil rigs for a specified period of time in which the employer paid for their housing on the oil rig. Logically, it makes sense for these individuals to be denied the FEIE because they incurred no financial detriment or personal out-of-pocket costs by living outside the U.S. while they maintained residences in the U.S. for their time off.
The second requirement for the FEIE is that a taxpayer either be a bona fide resident of a foreign country (bona fide residence test), or be present in a foreign country for 330 days in 12 months (presence test).
Bona Fide Residence Test
This option is only available to U.S. residents and not resident aliens. To be a bona fide resident of a foreign country a taxpayer must go to that country for an indefinite period and set up permanent quarters. The taxpayer must also reside in that foreign country for an uninterrupted period including an entire tax year (Jan 1 – Dec 31). You may take trips from this new residence, including to the U.S., so long as you intend to return to the new residence.
Presence Test
This test is simpler. It requires taxpayers be abroad for 330 total days. A taxpayer would qualify if she spent, for example, 110 days in Spain, Italy, or France. There are specific rules on what counts as a whole day. To be safe, place to be abroad for 331 or 332 days a year to meet this requirement. Most true digital nomads are going to meet this requirement rather than the Bona Fide Residence Test, since the presence test does not require setting up a permanent establishment in one country.
Let’s Review
A digital nomad traveling regularly will likely be an itinerant whose tax home moves with him from place to place. If he stays out of the U.S. for at least 330 days for the tax year, he will qualify for the FEIE.
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The Foreign Housing Exclusion
Technically the foreign housing exclusion is just a part of the foreign earned income exclusion (FEIE).
For simplicity, I’m separately the two concepts and giving them entirely different names and sections. The Foreign Housing Exclusion (FHE) allows taxpayers to increase their income exclusion amount based on housing expenses paid throughout the year.
The purpose of this is to . . .
The Baseline Rule
To be eligible to claim a foreign earned income exclusion, a taxpayer must meet the following conditions:
The taxpayer must qualify for, and claim, the Foreign Earned Income Exclusion;
The taxpayer must have “qualified foreign housing expenses”;
The taxpayer must have paid for those housing expenses through employer provided funds (kind of);
The housing expenses must exceed the base amount specified based on the location in which the expenses are incurred.
The 3rd part of the above rule requires that a taxpayer pay for their housing expenses with employer provided funds. Obviously, if a taxpayer is self-employed, she would not meet this rule. However, this is an exception to this rule for those making over the FEIE amount ($112,000 in 2022), so continue reading if that’s applicable to you. I'll break down each of these four requirements.
1. FEIE
The taxpayer must qualify for, and claim, the Foreign Earned Income Exclusion.
2. "Qualified foreign housing expenses.”
Qualified foreign housing expenses include rent, utilities (except for telephone, TV, and internet), parking fees, leasing fees, repairs costs, and furniture.
3. Employer Provided Funds
For purposes of this requirement, employer provided funds are any amounts paid to you by your employer where that amount is also included in your gross income. Unless the employer pays the expenses directly, AND the employee is not required to lump the value of those paid expenses into their income, the amounts paid towards expenses should be part of gross income.
Although this rule seems pretty black and white, there is a big exception. This exception only applies to those with income over the FEIE exclusion amount ($112,000 in 2022). The tax code has a provision allowing “special rules where housing expenses not provided by employer.” Self-employed individuals may deduct the lesser of their qualified housing expenses (as calculated in part C below) or their amount of foreign earned income in excess of the excludable amount. I know that is confusing. Allow me to illustrate with an example.
Assume, taxpayer has $154,100 of foreign earned income. In 2018, the FEIE limit is $104,100. Therefore, $50,000 of taxpayer’s income is not excludable. Assume also that taxpayer has $40,000 in qualified housing costs. Hypothetically, only $25,000 of that $40,000 is an excludable housing costs due to the calculations discussed below. Taxpayer has $25,000 of deductible housing costs and $50,000 of non-excludible income. The tax code allows taxpayer a deduction equal to the smaller of those two numbers. Here, that would be the $24,000. Note, that I’m underlining “deduction” here because this amount is a deduction and not an income exclusion like the FEIE.
In this example, taxpayer has an exclusion of $104,100 and a deduction of $24,000.
Let’s change up the example some and make taxpayer’s income $114,100. Now, the non-excluded amount of income is only $10,000. $10,000 is less than the $24,000 of housing costs, so the $10,000 is the deductible amount.
I noted above that this exception only applies to those making above the exclusion amount. That’s because where a taxpayer’s income is less than the exclusion amount, can be no amount over that threshold to consider. The amount “over the exclusion amount” is $0. The lesser of $0 and housing costs is always going to be the housing costs.
4. Location Based Amounts
This bit is rather complicated and is calculated in the steps below under “Amount to be excluded.”
Amount to be Excluded
I could easily write five pages on how exactly the housing exclusion is to be calculated. Instead, I will try my best to provide a simplified explanation of how the exclusion amount is calculated and what it means for you as a digital nomad.
The following steps assume that you were in more than one country during the tax year. If you only make it through a couple steps and think “O holy shit. I don’t want to read this. Just skip to the “The Key Takeaways" section.
Step 1
Find the number of qualifying days during the tax year that you spent in each country.
Step 2
Determine the allowable exclusion amount is to find the corresponding limit amount in the IRS instructions for the city in which you are claiming an exclusion or deduction
The IRS provides limits on housing expenses for major cities across the globe. Simply put, the tax code attempts to adjusted the allowable exclusion amount up or down based on the cost of living per city. The limits on housing expenses can be found at the end of the IRS Instructions for Form 2555. https://www.irs.gov/pub/irs-pdf/i2555.pdf
For example, we can see in the table the highest amount allowed is Hong Kong at $313.15 per day or $114,300 annually.
(Make sure to find the table for the most up-to-date year).
Step 3
Multiply the number of qualifying days in each city by the limit found in step two
Here is a visual example of these steps (the missing dates represent when our imaginary taxpayer was back in the U.S.):
Step 4
Add up the total allowable amounts for each city. This figure we will call the “limit on housing expenses.”
To do this, we simply add the three total amounts from the table in Step 3. The total is $86,379.83. Note that I chose the three cities in the table with the highest allowable exclusion amounts, so presumably the most expensive cities.
Step 5
Determine the qualified housing expenses for the tax year.
This figure represents your living costs which includes rent, utilities, property insurance, parking, household repairs, and furniture rental. The expenses must be “reasonable” and may not be “lavish or extravagant under the circumstances.”
Step 6
Determine the lesser of the step 5 amount and the step 4 amount.
Assume our taxpayer from Step 4 paid $90,000 during the year for qualifying living expenses. The lesser would be the $86,379.83 limitation.
Step 7
Apply the IRS limitation.
This step is a bit convoluted. First, you determine that total qualifying days abroad. Looking at the table in Step 3, we would add up the days in the middle column which totals 339 days (note this is over 330, which is how this taxpayer qualifies for the FEIE). Now multiply that number by $44.76. That total is $15,173.64. Lastly, take the answer from step 6 ($86,379.83) and subtract the $15,173.64, which equals $71,206.36.
If the taxpayer paid the expenses from employer funds – as discussed above – then this $71,206.36 represents the taxpayers housing exclusion. If the taxpayer were instead self-employed, she must go on to Step 8.
Step 8
Determine the percentage of days spent abroad during the tax year
The taxpayer above spent 339 out of 365 days out of the U.S. The percentage of days abroad would be 93%.
Step 9
Multiply the percentage in Step 8 by the maximum FEIE.
The max FEIE in 2018 is $104,100. That number multiplied by 93% equals $96,813.
Step 10
Determine the smaller of taxpayers foreign earned income and the total from Step 9.
Sticking with our same taxpayer, let’s assume she made $250,000. The smaller figure would be the $96,813.
Step 11
Subtract the total from Step 10 from the foreign earned income.
$250,000 - $96,813 = $153,187
Step 12
Determine the smaller of Step 7 ($71,206.36) and Step 11 ($153,187).
The smaller is – here it would be $71,206.36 – the amount that the taxpayer may deduct on her tax return.
Another Example
Here, let’s assume the following facts for a taxpayer named Phil. Phil paid $20,000 during the year for qualifying expenses, and his foreign earned income was $60,000. The following chart reflects his days spent abroad.
The above chart also reflects steps 1-3.
STEP 4: $33,872.95
STEP 5: $20,000
STEP 6: $20,000
STEP 7: $4,826.36
STEP 8: 93%
STEP 9: $96,813
STEP 10: $60,000
STEP 11: $0
STEP: 12 $0
The outcome is that Phil gets no foreign housing deduction.
Assume instead that Phil’s foreign earned income was $115,000. Everything would remain the same up until Step 11.
STEP 11: $18,187
STEP 12: $18,187
In this outcome, Phil makes above the max FEIE. Therefore, he gets a housing deduction of $18,187.
The Key Takeaways
If you did not follow all the rules and math in this section, the takeaways are this
If you either (1) have an employer and you incur out-of-pocket living expense costs or (2) are self-employed making over the exclusion amount ($104,100 in 2018 adjusted for inflation thereafter) you most likely can take either an exemption or a deduction for some of your living expenses.
The exemption/deduction amount is tied to the city or cities in which you resided based on expected cost of living in that city. Therefore, you can’t cheat the system by renting mansion in a less expensive country
The FEIE and Housing Exemption and Deduction are very complex. If you think you could benefit, hire a tax preparer with expertise on these issues.
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State Tax Residency Issues
Thinking back to our high school civics classes, we have all at some point learned about federalism in the U.S. We have a layered legal system of federal and state laws. Tax is no different. Each state has its own tax laws. The tax codes vary greatly by state.
In my masters of tax law program, the professors always said that working with the IRS was a breeze in comparison to the Franchise Tax Board, the California taxing authority. Some states, like California, have very strict rules.
Residency Rules
Some states apply a basic rule, like the IRS, where they will tax residents all income regardless of where it was earned. However, each state defines “resident” a little differently.
California considers a person a resident if the person is “present in California for other than a temporary or transitory purpose,” or if the person is “domiciled in California, but located outside California for a temporary or transitory purpose.” Determining a person’s domicile is tricky because it’s an issue of intent. The state looks to whether a person who is absent has an intent to return. This is important because California is likely to consider any nomads who were in CA before they began traveling to be domiciled and therefore residents of CA; thereby taxing all of their income.
New York’s rules are very similar to CA, but NY does provide a carve out for individuals who spent less than 30 days in NY for the tax year and maintained a “permanent place of abode” outside of NY. There are some other, more complex exceptions as well.
Washington state is more lax and provides that a person is a resident if she “maintains a residence in Washington for personal use.”
As you can see, the residency rules vary widely. They’re also very important. If a taxpayers is earning it’s income abroad, most states are only going to tax that income if the taxpayer is a resident of that state. In short, the yes/no answer to the residency question determines which state or states can tax you. It could be possible, for state tax purposes, to not be a resident of any state. If you want to dig into specific state rules more deeply start with a Google search of “_____ [insert state] residency tax rules.” Try to find the information on the state’s official taxing authority website.
Source Rules
California’s tax laws provide that residents are taxed on all income. Nonresidents are only taxed on income from California sources. This is where sourcing rules come into play. Wages are sourced to where the services are performed. If you perform services for an employer while in Brazil, CA would consider those wages to be Brazilian sourced income. You would only be taxed on those wages if you were a CA resident. Similarly business/freelance income, is sourced to where the business carried on. Items like real estate are based on location. This makes sense, right? If you sell a house in CA, it’s CA source.
New York, again, applies very similar rules. Nonresidents are only taxed on New York sourced income, and the sourcing rules are nearing identical to CA.
Tax Rates Across the States
`To complicate things more, each state has different state income tax rates.
Flat Tax States
Eight states (Colorado, Illinois, Indiana, Massachusetts, Michigan, North Carolina, Pennsylvania, and Utah) have flat tax rates ranging from around 3% to 5%.
No Income Tax States
Some states do not have income tax and do not require an income tax return. Those states are: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. Two other states, Tennessee and New Hampshire, only tax dividend and interest income.
Graduated Tax Rate Staes
The remaining states, have graduated tax brackets that work similarly to federal income tax. The states with the highest income tax rates in order from highest to lowest are: California (13.3%); Oregon (9.9%); Minnesota; Iowa; New Jersey; Vermont: District of Columbia; New York; Hawaii; Wisconsin (7.65%).
Other Taxes
Income tax, of course, is not the only issue regarding state tax. Most states also have sales tax and property tax. As a nomad, you likely need not concern yourself with sales tax, as it won’t be applicable if you’re not buying goods in the state. Property tax, however, could be a major consideration if you own or plan to own property. The highest property tax states are:
New Jersey – 2.38%
Illinois – 2.32%
New Hampshire – 2.15%
Connecticut – 1.98%
Surprisingly (at least to me), Hawaii is the lowest at 0.28% (I guess not that surprising because tourism).
I’m not going to dive into this too much. The point here is to consider and balance income tax with property tax. New Hampshire has no income tax on business income, but is a high property tax state. If you don’t own property, New Hampshire would be a great place to be domiciled.
Local Tax
Some states also have local income taxes. Those states include: Alabama; Colorado; Delaware; Indiana; Kentucky; Maryland; Michigan; Missouri; New Jersey; New York; Ohio; Oregon; Pennsylvania; and West Virginia. Note that the District of Columbia is considered a local tax, but the rate is higher than most cities as it’s effectively a state tax and in keeping with state tax rates (4%-8.5% based on income).
In most states, only the larger cities impose local taxes. Here is a sampling of cities and their rates.
Philadelphia: 3.9%
New York City: 2.9-3.6%
Portland: 0.6%
Note that California has the highest income tax, but has no local income taxes. New York City and Philadelphia have high local income taxes. When added the their state tax rates, those cities rival California has some of the highest taxed places to live. Similarly, Illinois has relatively high state tax and property tax, but no local tax.
Planning Considerations
At this point, you might be thinking “I’m so overwhelmed – what the hell am I supposed to do with this information.” Let’s assume that you are from Vermont, the state with the 6th highest income tax state. Maybe it would be worth taxing steps to change your tax residency before traveling the world. Moving a couple hours over to New Hampshire, who only taxes interest and dividends, could mean 7+% more money in your pocket come tax time.
As noted earlier, some states make it more difficult to transfer residency. California typically presumes an individual who was a resident still is a resident unless that individual affirmatively proves their non-residency. Here are some proactive steps individuals can take to show an intent of changing residency:
Get a new driver’s license in new state;
Transfer bank accounts;
Get a new library card;
Change voter registration;
If you own a home in the state from which you are trying to move, renting it on a longer-term lease will help show that you no longer intend to live there.
Also, be sure not to have any facts that would help a revenue agent from the former state argue that you never gave up your residency. For example, if you have a kid receiving in-state tuition in New York, that may be a problem if you are now claiming to be a resident of Pennsylvania after having moved from New York.
You may be asking how all this information comes into play. Let’s use an example. Assume a taxpayer has been living in California for five years. He has family in Washington state. He wants to become a digital nomad but still plans to come back to California a couple times a year to visit friends. The taxpayer leaves California at the end of January. Travels most the year, but goes back to California a twice for 10 days each. When he goes back, he stays in a home that he owns. The rest of the year, he rents it out on AirBnB. The following April, he files his tax return. He states that he is a resident of Washington because he moved most of his belongings into his parent’s garage. Sometime thereafter, the California Franchise Tax Board (FTB) send this taxpayer a letter saying that he owes $10,000 on his foreign earned income because he was still a resident of California while traveling. The taxpayer hires me to deal with the FTB on his behalf.
As taxpayer’s lawyer, I am going to use whatever facts I have to help show that taxpayer is no longer a resident of CA. If taxpayer only moved his belongings to his parents, and took no other steps listed above, I am likely going to be unsuccessful. The FTB will likely counter that since taxpayer merely rented his home on AirBnB, he clearly has an intent to move back in once he stops traveling. Remember the rule in CA is that a person is domiciled in CA if they are transitory but have an intent to return. If taxpayer instead, sold his home, got a new state ID in Washington, switched banks, and changed his voter registration, I am going to have a much better time arguing with the FTB.
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The Foreign Tax Credit
Although the General Rule allows the U.S. to tax its citizens on their worldwide income, the tax code has provisions that attempt to minimize the possibility of double taxation, two different nations taxing the same person on the same income.
The foreign tax credit is the main way to achieve this goal. The mechanism allows an individual to receive a credit against their U.S. tax in the amount of income taxes paid to other jurisdictions. Presumably, most digital nomads are moving often enough that they are not paying foreign governments taxes. Therefore, this section likely will not apply to most of you unless you have companies selling products in different countries.
The Rules
Here are the requirements for getting this credit:
The party seeking the credit must have been the payor of the credit; and
The foreign levy must have been a creditable tax
The first requirement is fairly straightforward. Being the payor of the tax means that the person seeking the credit is actually the one that owed the foreign tax, meaning that taxpayer may not get a foreign tax credit if taxpayer’s mom paid the foreign tax bill.
The second requirement has two subparts. First, to be creditable the tax must actually be considered a tax by U.S. standards. This means that amount paid to the foreign jurisdiction must not be certain to be credited, forgiven, or refunded. Also, fines, penalties, interest, royalties, and charges for specific economic benefits do not represent a tax for purposes of the credit. Second, the “predominant character” of the foreign tax must be the same as a U.S. income tax. The test has a few subparts in and of itself, but in short, it simply means that the tax charged by the foreign jurisdiction must look and act like a U.S. income tax.
The foreign tax credit can get quite a bit more complex particularly when there are corporations and subsidiaries involved. If your company pays a lot of income tax abroad, consult with someone who has expertise on foreign taxes and the foreign tax credit.
Example
Georgia is a web designer. She’s originally from Texas. While they travels extensively, their new home base is in Germany. Their net business income in 2022 is $150,000. Georgia also has additional sources of unearned income totalling $70,000. In 2022, Georgia paid $30,000 in taxes to Germany.
Georgia as an LLC formed in Germany taxed as an S Corp. Their annual salary is $60,000. Georgia owes 15.3% self-employment tax on that income totalling $9,180.
(For more on how S Corps work, check out this post).
$112,000 of the $150,000 in earned income is exempt from tax using the foreign earned income exclusion. Thus, the difference of $38,000 plus the $70,000 in unearned income, totalling $108,000 is subject to income tax. Georgia’s estimated effective income tax rate is 22%. U.S. income tax would be 22% of $108,000 or $23,760.
Totalling their income and self-employment tax, Georgia’s total owed to the U.S would be $32,940. However, under the U.S. tax treaty with Germany, Georgia gets a $30,000 credit for taxes paid to Germany. Their balance owed to the U.S. is $2,940.
Please note these numbers are purely hypothetical.
Banking, FATCA, and FBARs
Quick note on this section. These rules are scary. Prepare yourself. There are many details I have not included. The purpose of this section is make you aware of certain rules and scare you into carefully consider whether these rules apply to you, so that you may hire a professional for assistance.
Many online sources recommend that nomads put clients payments and other funds into international bank accounts. This advice is given for a few reasons. Here, I will not dive into those or otherwise discuss the ins and outs of choosing international banking options as I am not a financial advisor who can counsel on exchange rates, nor am I a licensed lawyer in each different prospective nation.
Here, I will discuss an often overlooked legal requirement. The Foreign Tax Compliance Act (FATCA). FATCA requires certain U.S. persons to report assets held outside of the United States. The penalties are severe, so read carefully.
What the Hell is a FATCA & an FBAR?
FATCA stands for the Foreign Account Tax Compliance Act. FATCA is a law that requires foreign financial assets be disclosed as part of a taxpayer’s tax return. An FBAR is a Report of Foreign Bank and Financial Accounts. The FBAR is separate from a tax return is a filed online with the Financial Crimes Enforcement Network (FinCEN), which is a bureau of the Treasury Department.
Who Must File an FBAR & When?
A U.S. person who has a financial interest OR signature authority over at least one financial account located outside of the U.S. where the aggregate value of all foreign financial accounts exceeded $10,000 at any time during the calendar year must file an FBAR.
The FBAR is due April 15th.
There are two pieces to this rule that trip up taxpayers. The first is the signature authority bit. Even if the money in the foreign account does not belong to the taxpayer, she must file an FBAR is she has signature authority over the account. This often occurs when a taxpayer has control over a child or some other person’s account. Taxpayers also have FBAR obligations when they control accounts in the name of foreign corporations.
The other tricky issues is the aggregate value bit. A taxpayer has a FBAR requirement if she has one foreign account with $10,001 or 15 accounts totaling $10,001.
FBARs are a common issue for non-citizens with green cards as they usually leave their assets in their home country accounts. However, nomads who choose to open foreign accounts need to be aware of these requirements.
To Whom Does FATCA Apply?
As noted above, FATCA rules effect requirements on a taxpayer’s tax return. Holders of foreign accounts may need to report foreign accounts on a Schedule B and Form 8938, Statement of Special Foreign Financial Assets.
U.S. citizen must report specified foreign financial assets on the 8938 if the aggregate value exceeds certain thresholds. The reporting threshold vary depending on a taxpayers’ filing status. Here are the thresholds (these numbers are taken from 2017 and subject to change):
Individuals filing as single – must report is the total value of specified foreign financial assets is more than $50,000 on the last day of the tax year OR more than $75,000 at ANY time during the year;
Married taxpayers filing joint – changes the numbers to $100,000 and $150,000 respectively;
Married taxpayers filing separately – same as those filing as single.
These numbers are increased for individuals who meet the foreign tax home test (see the 2nd rule under the FEIE). For these individuals, the numbers change to the following:
Single filers & married filing separately - $200,000 the end of the year OR $300,000 at any time during the year.
Married taxpayers – the numbers change to $400,000 and $600,000
What are "Foreign Financial Assets?"
The IRS pretty clearly lays out what are deemed foreign financial assets. Here is exactly what the applicable IRS form instructions (8938) define as specified foreign financial assets:
Specified foreign financial assets include the following assets.
Financial accounts maintained by a foreign financial institution.
The following foreign financial assets if they are held for investment and not held in an account maintained by a financial institution:
Stock or securities issued by someone that is not a U.S. person (including stock or securities issued by a person organized under the laws of a U.S. possession),
Any interest in a foreign entity, and
Any financial instrument or contract that has an issuer or counterparty that is not a U.S. person (including a financial contract issued by, or with a counterparty that is, a person organized under the laws of a U.S. possession).
As you can see, the definition is quite broad. The instructions also go on to define each of the items in that definition. You check that out by Googling the IRS Form 8938 Instructions.
Penalties
Failure to meet the FATCA and FBAR requirements each have penalties.
The FBAR penalty for failing to file differs depending on whether the failure was “willful” or “non-will.” I’m not going into the specifics on how those are defined here. The penalty for willful noncompliance is up to the value of the account over an audit period. You read that right. If you have a foreign account with $100,000 in it, and you fail to report that account, the penalty may be $100,000. The penalty for a non-willful taxpayer is lower and is determined based on various facts and circumstances
The penalty for failing to file the form 8938 when required by FATCA is up to $10,000. If a taxpayer receives notice of the failure to file and fails to then file within 90 days, the taxpayer may be subject to an additional penalty of $10,000. The penalty countinues to accrue at that point in the amount of $10,000 per everything 30 days the taxpayers fails to file until the total penalty accrues to (and maxes out at) $60,000.
In Conclusion...
As you can see, these foreign account disclosure processes are not something to take lightly. If you think they may apply to you, consult with a tax attorney who specializes in international tax to determine your requirements and remedies to previous non-compliance if that applies to you.
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