Foreign Income Tax Rules

The United States uses citizenship-based taxation (CBT) — meaning US citizens and permanent residents (green card holders) are required to file US federal tax returns and pay US tax on their worldwide income, regardless of where they live or work. This applies even if you have lived abroad for decades and earn no US-source income.

This is fundamentally different from how most countries operate: the vast majority of nations use residence-based taxation, taxing only income earned within their borders. As a result, US expats face potential double taxation — the country where they live wants to tax their local income, and so does the US.

Tax System	Who It Covers	Examples
Citizenship-based (US, Eritrea)	All citizens globally, regardless of residence	US citizen living in Germany files US and German returns
Residence-based (most countries)	Only residents; emigrants stop filing	German citizen living in Spain files only Spanish return

Two primary tools exist to prevent true double taxation for US persons abroad: the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC). Most expats use one or the other — rarely both on the same income.

Warning: Renouncing US citizenship eliminates future filing obligations but triggers the expatriation tax (Section 877A) for covered expatriates — generally those with net worth above $2 million or average annual net tax above $201,000 (2025 threshold). The deemed-sale rule treats your assets as if sold on the day before expatriation.

The Foreign Earned Income Exclusion (FEIE), claimed on Form 2555, allows qualifying US citizens and residents abroad to exclude a specified amount of foreign-earned income from US federal income tax each year. For 2025, the exclusion amount is $130,000 (adjusted annually for inflation).

Feature	Details
2025 exclusion limit	$130,000 per qualifying individual
Qualifying income types	Wages, salaries, self-employment income earned in a foreign country
Excluded income types	Passive income (interest, dividends, capital gains), pensions, Social Security
Housing exclusion / deduction	Additional exclusion for housing expenses above a base amount ($20,800 for most locations in 2025)
Required residency tests	Bona Fide Residence Test OR Physical Presence Test

• Bona Fide Residence Test: You must be a bona fide resident of a foreign country for an uninterrupted period that includes a full tax year. Requires domicile and genuine integration into the foreign country.
• Physical Presence Test: You must be present in a foreign country (or countries) for at least 330 full days in any consecutive 12-month period. More mechanical — days in country simply count.
• Tax cost of FEIE: Excluded income is removed from your tax base, but the remaining income is taxed as if it were piled on top of the excluded income — this is the stacking rule, which can push other income into higher brackets.

Tip: The FEIE is most beneficial when you have little or no foreign income tax to credit — for example, expats living in low-tax or zero-tax countries like the UAE, Cayman Islands, or Singapore.

The Foreign Tax Credit (FTC), claimed on Form 1116, allows US persons to offset their US federal tax liability dollar-for-dollar with foreign income taxes paid or accrued. Unlike the FEIE (which excludes income), the FTC reduces the actual tax owed.

Feature	Details
Credit type	Dollar-for-dollar reduction of US tax liability
Qualifying taxes	Income taxes paid to foreign governments; not VAT, sales tax, or property tax
Limitation	US tax on foreign income only; cannot exceed US tax attributable to foreign source income
Carryback / carryforward	Unused FTC can be carried back 1 year or forward 10 years
Per-basket rules	Credits are calculated separately for passive income, general income, and other baskets

The FTC is most powerful when you live in a high-tax country (Germany, France, Scandinavia, UK) where the local tax rate exceeds or matches the US rate. In that case, the foreign taxes paid fully offset US tax, often resulting in zero US tax owed. The FTC cannot create a refund — it can only reduce tax to zero.

• Simplified limitation election: Available for taxpayers with less than $300 ($600 MFJ) of foreign tax paid who can skip Form 1116 and claim the credit directly on Schedule 3.
• Accrual vs cash basis: The FTC can be claimed on either a cash (taxes paid) or accrual (taxes accrued) basis. You must be consistent year to year.

Tip: Many US expats in high-tax countries (e.g., Germany at 42% top rate) find the FTC eliminates their US tax liability entirely and generates a carryforward credit that can be used against future income. Run projections both ways before choosing FEIE vs FTC.

The choice between the FEIE and FTC is one of the most consequential decisions for US expats — and it is not always obvious which is better. You can switch between them, but revoking the FEIE election locks you out of it for five years.

Factor	Use FEIE	Use FTC
Local tax rate vs US rate	Low-tax country (no FTC available to offset)	High-tax country (FTC fully offsets US liability)
Income type	Earned income only (wages, self-employment)	Passive income (dividends, interest) only eligible for FTC
Social Security contributions	FEIE does not reduce SE tax — you still owe SS on excluded income	FTC reduces income tax but SE tax still applies without totalization agreement
Roth IRA contributions	FEIE reduces earned income, which can reduce Roth IRA eligibility	FTC does not reduce earned income for IRA purposes
US tax result	Often zero US tax in low-tax countries	Often zero US tax in high-tax countries; carryforward generated

A common expat mistake: claiming the FEIE while living in a high-tax country means forfeiting foreign tax credits on the excluded income — wasting valuable credits. Conversely, using FTC in a zero-tax country means you owe full US tax with nothing to credit against it.

Warning: Self-employment income excluded under the FEIE is still subject to US self-employment tax (15.3%) unless a totalization agreement with the foreign country covers it. The US has totalization agreements with about 30 countries — check the SSA website for the current list.

Beyond income tax, US persons with foreign financial accounts and assets face two additional reporting regimes: FBAR and FATCA. Both carry severe penalties for non-compliance — and neither is triggered by owing tax. These are pure information reporting requirements.

Requirement	Form	Threshold	Deadline	Filed With
FBAR (Foreign Bank Account Report)	FinCEN Form 114	Aggregate foreign account balances > $10,000 at any point during the year	April 15 (auto-extended to October 15)	FinCEN (not IRS) via BSA E-Filing
FATCA (Foreign Account Tax Compliance Act)	Form 8938	$200,000 at year-end or $300,000 at any point (single abroad); $400k/$600k for MFJ abroad	With your tax return	IRS, attached to Form 1040

• FBAR penalties: Non-willful failure: up to $10,000 per violation (per account per year). Willful failure: up to the greater of $100,000 or 50% of account balance per violation. Criminal penalties possible for willful violations.
• FATCA penalties: $10,000 failure-to-file penalty plus $10,000 for each 30-day continuation period after notice from IRS, up to $50,000.
• Streamlined procedures: US persons who failed to report foreign accounts non-willfully can use the IRS Streamlined Filing Compliance Procedures to come into compliance with reduced penalties (5% penalty on foreign assets for US residents; $0 penalty for expats).
• Foreign accounts covered: Bank accounts, brokerage accounts, mutual funds, pension plans, and certain foreign insurance policies. Does not generally include real property owned directly (use FBAR only for accounts holding real estate, not direct real property).

Warning: Many foreign financial institutions now refuse US person clients due to FATCA compliance costs. If you are a US expat, opening and maintaining bank accounts abroad can be challenging — contact the US embassy for a list of FATCA-compliant banks in your country of residence.