Four Critical Year-End Tax and Investment Considerations for American Expats
Thun Financial Advisors, Copyright © 2017
This article offers four important tax and investment moves that American expats should make before year-end. These include:
- Sell Foreign Mutual Funds to purge portfolios of Passive Foreign Investment Companies (PFICs). PFICs are tax-toxic investments in the U.S. context and owning them for even one day in the new year will trigger complex and costly reporting for yet another year.
- Make Charitable Contributions to maximize the tax benefit in 2016 ahead of potential tax rate declines under the new Republican administration in the U.S. Also, coordinate U.S. charitable giving rules with country-of-residence rules to ensure that the maximum tax benefit is derived. Consider using a Donor Advised Fund.
- Know Your Deadlines for retirement account contributions and tax-year filings so that deductions are properly allocated across both U.S. and local tax jurisdictions even when contribution deadlines differ. Also, coordinate taxable transactions carefully if your local jurisdiction does not end its fiscal year on December 31, as in the U.S.
- Take Advantage of Tax-Loss Selling Opportunities to minimize annual taxable gains. However, avoid using U.S. rules of thumb about offsetting losses with gains, carrying losses forward and using capital losses to offset taxable earned income. Tax efficiencies achieved in a pure U.S. environment may be lost after factoring in country-of-residence tax rules and can even have the effect of raising the total amount of tax due in some cases.
1. Selling Foreign Mutual Funds
American expats commonly find that they hold investments in foreign mutual funds. Properly reporting foreign mutual funds to the IRS is often the most burdensome aspect of owning these investments. Full IRS annual reporting is required even if the investment is owned for only one day in a given year. For this reason, it may be particularly advantageous to sell foreign mutual funds before the beginning of a new tax year.
Beyond the additional reporting burden, foreign mutual funds are typically not tax-efficient investments. These foreign mutual funds, also known as passive foreign investment companies (PFICs), are subject to special, highly punitive tax treatment by the U.S. tax code. Generally, owners of PFICs are taxed at the highest federal marginal rates, PFIC gains cannot be deferred, and PFIC losses cannot offset other non-PFIC investment income.
American expats encounter foreign mutual funds most commonly in foreign pension plans. The IRS PFIC rules apply to these pension plans unless those plans are recognized by the U.S. as “qualified” under the terms of a double-taxation treaty between the U.S. and the host country. Thus, American expats must pay careful attention to the tax reporting of these accounts to avoid the PFIC tax trap.
Proper annual IRS reporting requires significant recordkeeping and expertise. American expats could greatly simplify their U.S tax situation by simply selling any foreign mutual funds and liquidating old foreign pensions (if permissible by local law). This would not only lower taxes, but significantly reduce tax preparation costs, since reporting on Form 8621 (PFICs) and Form 3520 (Foreign Trusts) would be unnecessary. Remember, even if the PFIC is owned for one day in the tax year, it must be fully reported to IRS standards. An expat who cannot liquidate a PFIC or pension should work closely with a qualified tax preparer to mitigate these difficulties.
Foreign mutual funds and their tax implications for the American expat investor are covered in greater detail in “Why Americans Should Never Own Shares in Foreign Mutual Funds.”
2. Making Charitable Contributions
By the end of the calendar year, Americans abroad should have a clear understanding of their tax liabilities and where they owe them. Along with the “spirit of the season,” year-end consequently becomes a particularly good time to consider charitable giving to reduce tax exposures. One way to do this is through gifting in the country of residence. The U.S. has treaties with three countries (Mexico, Canada, and Israel) where contributions in one country can be deducted in the other. More importantly, U.S. expats can frequently reduce their foreign tax bills (though not their U.S. bill) if they are in higher tax jurisdictions by donating to charities in their country of residence. Expats must ensure that such donations are fully compliant with local tax laws.
However, Americans will want to be careful not to give so much that they end up creating a new tax burden in the U.S. Americans in countries with lower tax rates than in the U.S. who owe U.S. taxes will want to make such contributions to a 501(c)3 organization, a fully tax-compliant American charity. Given President-elect Donald Trump’s proposals for changes to the tax code, which may reduce both deductions and tax rates, Americans abroad might get the best value for their charitable contributions by making a large one-time donation to a “Donor Advised Fund” this year. Such a donation could eliminate current-year taxes while allowing the donor to continue giving to a variety of charities over the next several years. However, be aware that Donor Advised Funds may trigger country of residence compliance and tax consequences.
Donor Advised Funds and other tax-compliant gifting strategies are covered in greater detail in our recent research article “Cross-Border Philanthropic Strategies.”
3. Knowing Your Deadlines (Here and There) for Pension and Retirement Account Contributions
U.S. taxpayers with individual retirement plans such as IRAs, Roth IRAs, SEP IRAs and 401ks should always seek to understand IRS deadlines for making contributions to receive a current-year tax deduction. Most investors understand that they have until the initial filing deadline of April 15, without extensions, in the year following the tax year in which to contribute to a traditional or Roth IRA. 401k plans have two important funding deadlines: the employee contribution deadline of December 31 of the tax year, and the employer contribution deadline of April 15, plus extensions, of the tax year. The self-employed taxpayer contributing to a SEP IRA has until the extended due date of the tax return to also make a contribution for that tax year. The rules that apply to making contributions to U.S. retirement plans are quite specific to the type of retirement plan being used, and the U.S. taxpayer needs to be aware of the relevant deadlines that apply to his given plan.
Country-of-residence tax rules may alter the appropriate scheduling of contributions to U.S. qualified retirement accounts. For example, if you are a resident of France, you may want to make a contribution to a U.S. retirement account (if eligible) and claim a deduction on your French income tax return. This is possible under the U.S.-France income tax treaty. However, you may be making a serious mistake and setting yourself up for improper tax reporting in France if you only consider U.S. deadlines for deductible contributions. You must also consider the deadlines applicable in France.
In general, an expat claiming an income tax deduction on his foreign income tax return for a contribution to a U.S. qualified retirement plan (where allowed) should make sure that the contribution was made during the tax year in which the deduction is claimed. In most cases, that means by December 31.
In the United Kingdom, however, the tax year does not follow the calendar year. The tax year ends on April 5 and a new one begins on April 6. This means that contributions to retirement plans in the U.S. are subject to a January 1-December 31 calendar and to an April 6-April 5 calendar in the U.K. Beyond retirement plan contribution issues, the recognition of income and gains and losses from sales of assets in the January 1-April 5 period will appear on different years’ tax returns in the U.S. and the UK. In addition to the United Kingdom, other countries observe tax years for individual filers that do not follow the calendar year, including Australia (July 1-June 30), New Zealand (also July 1-June 30) and South Africa (March 1-Feb 28/29).
Usually, tax payers will want taxable events to occur in the same tax year for both countries. However, in some cases, timing a transaction so that it occurs in different tax years between the U.S. and the country of residence may offer an opportunity for strategic cross-border tax optimization—but also the potential for costly tax mistakes.
4. Taking Advantage of Tax-Loss Selling in a Cross-Border Environment
Smart U.S. investment planning includes exploiting the tax benefits of tax-loss selling before the year’s end. In a purely U.S. tax context, realized losses can be used to offset taxable gains elsewhere in the portfolio. When losses exceed gains, up to $3,000 of capital losses can be used to reduce taxable earned income and any remaining unused loss can be carried forward for use in future years. Therefore, tax-loss selling is normally an unambiguously effective technique to reduce the amount of taxes owed.
U.S. expat investors may lose the benefit of tax-loss selling once local tax rules are factored in. In some cases, the effect of tax-loss selling may increase the net tax owed. For example, when more losses are realized than can be used to offset capital gains elsewhere in the portfolio, U.S. rules will apply up to $3,000 dollars of the loss against earned income, thereby reducing taxable earned income. For an American in Germany (or in other high-tax countries), however, the calculation is very different. German rules will not allow the capital loss to reduce taxable earned income. Therefore, no tax benefit in Germany accrues from the loss. U.S. taxable income is reduced, but this produces no benefit normally because higher German tax rates mean that the entire U.S. liability is eliminated with foreign tax credits from taxes paid in Germany. This would be true with or without the reduction in U.S. taxable earned income because of the capital loss carry over. The benefit of the excess tax-loss that accrues in a pure U.S. tax environment is negated by German tax rules. However, the full extent of the problem is not just that no tax benefit accrues. Tax-loss selling is beneficial because it accelerates losses in order to reduce current taxation. It implies, however, that the loss will no longer be available to offset future gains and future capital gains will therefore be higher. So, if the loss is forfeited without benefit in the current tax year, the net result will be to increase rather than decrease the overall tax burden.
In some countries, however, a standard U.S. tax-loss selling strategy may still work. Hong Kong, for example, has low tax rates, only taxes locally-sourced income, and does not have capital gains tax. For U.S. expats earning above the Foreign Earned Income Exclusion limit (currently $101,300), accumulating excess tax losses will generally reduce their net U.S.-Hong Kong combined tax liability. This is true because lower Hong Kong tax rates are never sufficient to offset U.S. tax obligations. Carrying forward unused losses will generate further tax benefits in subsequent years until the losses are used up.
Another hidden peril in applying standard U.S. tax-loss selling strategies is that a U.S. loss may be a gain when accounted for in the currency of the U.S. expat’s local currency. Capital gains in the U.S. and most foreign jurisdictions are calculated as the difference between the market value of an investment and the original cost basis (price paid). Since the basis must be calculated based on historical exchange rates at the time the investment was purchased, a loss for tax purposes in one country may be a gain for tax purposes in the other country. This is especially true if there has been a large change in relative currency values during the period the investment was owned.
For example, an American investor resident and taxable in the UK may own an investment that has suffered a significant loss and is ripe for tax-loss selling under U.S. rules. However, when the basis and the sale price is recalculated in pounds, the loss might very well turn into a gain for U.K. tax purposes. Therefore, the unintended outcome of selling the investment is to create an unexpected U.K. tax liability with no offsetting U.S. tax benefit.