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When COVID-19 resurfaced in early 2020, most people thought telecommuting was a temporary phenomenon. However, many employers are offering their employees the option to continue working remotely after the offices reopen. In some cases, they have the ability to work from the location of their choice, even outside the United States. Thanks to many remote work programs, many Americans have temporarily relocated their residences to countries such as Iceland, Dubai, or the Bahamas. However, before you embark on digital nomad, you need to be clear about your tax obligations at home and abroad.
Do I have to pay taxes in the country where I am located?
Many countries that offer visas to digital nomads do not tax income generated outside the country. In Bali, for example, you can stay for up to five years without paying income tax. Dubai and Costa Rica are also exempt from income tax. It is advisable to research the possible destinations before making a final decision. In addition to the tax implications, you should also consider the application requirements and fees. The length of stay is also different if you are traveling on a digital nomad visa. If you are traveling to a country where there is no nomad program, you should generally not stay longer than six months to avoid possible taxation and double taxation.
Do I have to pay income tax in the United States?
Unfortunately, living abroad and working remotely does not exempt you from paying U.S. taxes. The U.S. is one of the few countries that taxes its citizens, no matter where they are located. This means that you must pay federal income tax and, in some cases, state and local taxes. Always check with the tax authorities in your country of residence to find out what taxes you owe abroad.
However, you can reduce or eliminate your tax liability during the federal tax season by using the foreign tax credit or the foreign employment income credit.
Foreign Tax Credits
If you pay foreign taxes in another country and are taxable in the U.S. on the same income, you may be entitled to a credit or deduction for that tax. In most cases, it is best to use a credit that will reduce your U.S. tax liability. To qualify for a foreign tax credit, the following conditions must generally be met
- The tax must have been collected.
- The tax must have been paid or incurred.
- Be a legal and effective foreign tax liability.
- The tax must be an income tax (or tax in lieu of income tax).
To claim the credit, Form 1116, Foreign Tax Credit, must be filed.
Deduction for foreign earned income
To exclude foreign earned income and reduce your U.S. federal income tax, you must spend at least 330 out of 365 days outside the United States. This is called the physical presence test. On the other hand, a digital nomad visa is usually sufficient proof of permanent residence in another country. This entitles them to a foreign income exemption under the “bona fide resident” test.
To qualify for the exemption, you must file IRS Form 2555, Foreign Earned Income, along with your Form 1040; in 2021, you can exclude up to $108,700 USD from your income. In addition to the foreign income exclusion, you may also claim a deduction or exemption from gross income for reasonable housing expenses (foreign income deduction or exemption).
If you work for a U.S. company or are self-employed, you must pay Social Security taxes. There are several ways to reduce your liability, usually by setting up your business overseas or entering into a stacking agreement. It’s also important to remember that failure to pay social security tax can affect future payments.
Seek advice from a tax expert
If you’re considering becoming a digital nomad, you should consult a tax expert before making any plans. When in doubt, don’t be reluctant to seek professional assistance. They can help you determine what returns you need to file, such as the Foreign Bank Account Report (FBAR) and the Declaration of Foreign Financial Assets (Form 8938), and they can help you find ways to reduce your tax burden. Be sure to ask before you leave for your new destination.
About Author
Villie Walters Ramirez is a 32-year-old tax consultant at a Manhattan tax audit firm who enjoys tax filing, accounting, and bookkeeping. She has a post-graduate degree in accounting, and she has a severe phobia of cats. Further, she enjoys traveling A lot.
