If you earn passive income while living abroad, understanding the ins and outs of passive income US expat tax is essential. You may be juggling dividends, interest, royalties, or capital gains on top of raising a family in Hong Kong, China, or Macau. Knowing how the IRS treats these earnings can help you maximize family tax benefits, including the Child Tax Credit, and avoid costly pitfalls. Below, we guide you through what counts as passive income, how it’s taxed, and how you can file correctly from overseas.
Understand passive income basics
Passive income is generally unearned income that does not come from wages or direct services. Common examples include:
- Stock dividends and interest payments
- Rental income from real estate
- Royalties from creative works
- Capital gains on the sale of assets
- Income from certain investment funds (e.g., PFICs)
Unlike foreign earned income, passive income cannot be excluded using the Foreign Earned Income Exclusion. Instead, you often rely on the Foreign Tax Credit (FTC) to offset U.S. tax liability. This credit provides dollar-for-dollar relief for taxes you pay to foreign governments but may be less effective if you live in a low-tax country or if your foreign tax rate is lower than what the IRS charges.
If you want a deeper look into how dividends, interest, and capital gains are handled, you can refer to our resource on US expat investment income rules.
Explore U.S. taxation on passive income
As a U.S. citizen or resident alien, your worldwide income is subject to U.S. tax, even if you live in Hong Kong, China, or Macau year-round. For passive income types like dividends, interest, or capital gains, you will typically face:
- Ordinary income tax rates (0% to 37%) on interest or non-qualified dividends
- Lower capital gains rates (0%, 15%, or 20%) on long-term gains and qualified dividends
- The Net Investment Income Tax (NIIT) of 3.8% if your modified adjusted gross income exceeds certain thresholds
Remember that certain expense deductions or credits may reduce your IRS bill, such as the FTC. However, if your local tax rates are below U.S. levels, you could still owe the difference. Additionally, many U.S. tax treaties contain a “saving clause” allowing the U.S. to tax citizens as if the treaty never existed, so you don’t always benefit from reduced tax rates abroad.
For more on dividends specifically, check out US expat dividends tax.
Plan for PFIC implications
If you have shares in a foreign mutual fund or certain foreign corporations, you may hold a Passive Foreign Investment Company (PFIC). Under IRS rules, PFIC income is subject to complex tax calculations, and failing to make timely elections or file Form 8621 can trigger significant taxes and penalties.
- By default, PFIC gains are taxed at the highest ordinary rate plus interest charges.
- The Qualified Electing Fund (QEF) or Mark-to-Market (MTM) elections may offer some relief, but each involves specific forms and deadlines.
- PFIC rules continue to evolve, so it’s wise to stay updated and file correctly.
We offer more details on PFIC rules for US expats and PFIC compliance requirements US expat. If you suspect you have PFICs, addressing them early can save you headaches later.
Claim family tax benefits from abroad
One of the biggest concerns for U.S. expat parents is ensuring they maximize family-related tax benefits, including claiming dependents and qualifying for the Child Tax Credit (CTC). Here are a few key considerations:
Verify dependent eligibility
- Your child must have a valid U.S. Social Security Number (SSN) to claim the Child Tax Credit.
- If you have a non-citizen child who qualifies as a dependent, you may need to obtain an Individual Taxpayer Identification Number (ITIN) instead, though that will not make you eligible for the standard Child Tax Credit.
- The child generally needs to live with you for over half the year, even if that residence is outside the U.S.
Use the Child Tax Credit wisely
- The Child Tax Credit can be worth up to $2,000 per qualifying child, under current guidelines.
- Part of the credit may be refundable, so you could receive a refund even if no U.S. tax is owed.
- Be sure you meet all IRS residency and relationship requirements to avoid any filing issues.
By optimizing your CTC or other dependent-related tax breaks in conjunction with passive income strategies, you can significantly lower your overall tax burden.
File essential forms from overseas
Living abroad means you may have additional reporting responsibilities. The following forms often come into play for passive income:
- Schedule B for interest and dividends
- Schedule D for capital gains
- Form 1116 to claim the Foreign Tax Credit
- Form 2555 to claim the Foreign Earned Income Exclusion (not applicable for passive income, but relevant if you also earn wages)
- Form 8621 if you hold PFICs
- Form 8938 to report specified foreign financial assets
- FinCEN Form 114 (FBAR) for foreign accounts exceeding $10,000
Note that when you claim the Foreign Earned Income Exclusion (Form 2555), you cannot take the Foreign Tax Credit on that same excluded income. For passive income, however, the FTC remains one of your best tools to prevent double taxation.
Consider social security taxes for self-employed expats
If you have self-employment income on top of your passive income, remember that the FEIE does not exclude self-employment taxes (15.3%). You may owe these taxes even if your overall U.S. income tax is zero. Additionally, you might encounter complexities if your passive income is intermingled with a small business structure, so plan carefully to stay compliant.
Frequently asked questions
Below are some common questions from expats managing passive income abroad.
Do I still file U.S. taxes if I owe $0?
Yes. You are generally required to file a U.S. tax return if your income meets the filing threshold, even if your final tax bill is $0.
How do I claim the Child Tax Credit?
You must include your child’s SSN on your U.S. tax return. For overseas births, you can apply for a U.S. birth certificate and SSN at the local U.S. consulate. Make sure you have proper documentation and meet the residency tests.
Can I use the Foreign Earned Income Exclusion for dividends?
No. The FEIE only applies to earned income like wages or business profits. Dividends, royalties, and other investment earnings do not qualify for that exclusion.
What if I missed PFIC reporting?
Promptly correct the oversight by filing Form 8621 for each PFIC you hold. You may also need to consult a tax professional if you face potential penalties.
Key takeaways
- You are taxed on all worldwide income, including passive income, as a U.S. expat.
- The Foreign Earned Income Exclusion does not apply to unearned income such as dividends or capital gains.
- The Foreign Tax Credit is generally your best defense against double taxation on passive income.
- PFICs require special reporting and have unique taxation methods, so file Form 8621 if you hold these investments.
- Claiming dependents and the Child Tax Credit from abroad is possible, provided your child has an SSN and meets IRS eligibility rules.
- Living in Hong Kong, China, or Macau does not negate your U.S. filing obligations. You must still report worldwide income and foreign accounts if you exceed filing thresholds.
For more insights on capital gains and other aspects of investment income, visit investment income taxation US expat. If you need personalized support, our team at American Pacific Tax is here to guide you. We understand the challenges of raising a family in Hong Kong, China, or Macau while juggling complicated U.S. tax rules, and we’re ready to help you minimize your taxes and maximize your benefits. Feel free to reach out for a consultation and find peace of mind in your tax season.