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If you’re an American expat living in Israel, you probably have questions about your U.S. tax responsibilities. Do you need to file? Will you have to pay taxes in both Israel and the U.S? What are the filing deadlines?
Let’s explore some of the most relevant tax issues for the Israeli-US expat.
US citizens and Lawful Permanent Residents (green card holders) are obligated to report all sources of worldwide income to the Internal Revenue Service of the United States, independent of whether or not they actually reside in the United States (excluding certain low income earning individuals). This means that if you are a US citizen living in Israel, you need to file an annual Form 1040 – individual income tax return – reporting all sources of income, including wages, interest, dividends, capital gains, partnership distributions, rental income, etc. and will be subject to US taxation.
In addition, there are other filing requirements that may apply if you fulfill certain conditions. The most common is the Foreign Bank Account Report (FBAR), a FinCEN information return. Others include Form 5471 (Information Return of U.S. Persons With Respect to Certain Foreign Corporations), Form 3520 (Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts), and Form 8938 (Statement of Specified Foreign Financial Assets). These are filings that report required information, but generally do not result in the assessment and payment of tax.
As a US citizen living abroad, you are entitled to an automatic two-month extension to file your US tax return. This changes your filing deadline from April 15th to June 15th. Furthermore, you can apply to extend your filing deadline until October 15th; application for this must be made by June 15th. If more time is needed, an additional two-month discretionary extension can be requested, which will extend the filing due date to December 15th.
These extensions only extend your time to file, not your time to pay taxes due. Interest on taxes due begins to accrue on April 15th. However, the late-payment penalty will only apply if taxes are not paid by June 15th. In contrast, the late-filing penalty does not apply unless the tax return is filed after all valid extensions.
In regard to the FBAR, the deadline is April 15th. If you do not file by April 15th, your deadline is automatically extended until October 15th. There is no need to file for this extension.
As a resident of Israel you will also be subject to Israeli taxation on your world-wide income. No one wants to be taxed twice on the same income; US tax laws and the US-Israel tax treaty provide for several helpful ways to avoid double taxation.
One of the most common and effective allowances for avoiding double taxation is the Foreign Tax Credit. Taxes paid to Israel on Israeli-sourced income can be used to offset US taxes due; this means that for every dollar of Israeli income tax paid, your US tax assessed is reduced by one dollar. Since Israeli tax rates are generally higher than US tax rates, a US citizen with Israeli-sourced income is often left with no US tax obligation at all. If you paid more tax to Israel than you are utilizing for the foreign tax credit, the excess foreign taxes can be carried forward for up to ten years as future credits. The foreign tax credit is limited to the percentage of total income that is foreign-sourced.
Furthermore, as per the US-Israel tax treaty, certain types of income sourced in the US can be re-sourced to Israel for foreign tax credit purposes, thereby allowing Israeli taxes paid to offset US taxes due. As per the treaty, US capital gains reported on Form 1099B and US pension income reported on Form 1099R can be treated as Israeli sourced income for the specific purpose of being able to utilize Israeli taxes paid as a credit to offset US taxes due. (In specific situations a portion of US sourced interest and dividend income may be re-sourced to Israel as well.)
Another provision of the Internal Revenue Code, specifically aimed at the avoidance of double taxation, is the foreign earned income exclusion (FEIE). You can utilize the FEIE, also known as Section 911 election, to exclude the first $105,900 (in 2019) from U.S. taxable income, by demonstrating that you qualify for the exclusion based on either the physical presence test or the bona fide residence test. This exclusion applies only to earned income, like wages and self-employed business income, and not to passive income, like interest and dividends. Foreign taxes paid on income that is excluded via the FEIE are not eligible to be used for foreign tax credit purposes.
Employer contributions to Israeli pension plans and sabbatical leave funds (keren hishtalmut) are not taxable in Israel in the year contributed; however, these contributions are taxable as wages in the US, since they do not qualify as eligible 401k contributions. The upside of this is that the principal portion of Israeli pension and sabbatical plans are not taxable on the US tax return upon withdrawal, as they were already effectively taxed in prior years. Only the income earned in the plan would be taxable for US purposes in the year of withdrawal.
Investments in Passive Foreign Investment Companies (PFICs), eg keren ne’emanut (Israel mutual fund) can also trigger a US tax liability, even though no taxable event actually happened according to Israeli tax law.
Another situation that very often triggers a large US income tax liability is the sale of one’s principal residence. In Israel, the sale of one’s principal residence is generally not taxed, or taxed minimally, whereas in the US, only $250,000 ($500,000 if married filing jointly) of the capital gain is excludable from taxable income and in order to qualify for the exclusion, the seller must have lived in the home for two out of the five years prior to sale. Moreover, if the property was being rented out, the “depreciation recapture” comes back to bite on the US tax return, resulting in a larger capital gain.
All high-earning individuals with income from passive sources are subject to US net investment income tax (NIIT). This is a 3.8% flat tax assessed on passive income of individuals who earn more than $200,000 ($250,000 threshold for married filing jointly taxpayers), and it applies even to passive income from Israeli sources. Many Israeli residents in this situation are unpleasantly surprised by this tax, as the Israeli income tax they paid on their passive income cannot be used to offset the NIIT.
Unfortunately, to date there is no totalization agreement between the United States and Israel. As such, US citizens who are self-employed in Israel will be subject to both the Israeli national insurance (bituach leumi) withholding and US FICA tax. This means double taxation by the social security systems of the two countries. As such, the self-employed setup is not ideal at all for a US citizen residing in Israel, as the result is the requirement to pay approximately 30% self-employment tax (15% US self-employment tax + 15% Israeli bituach leumi), in addition to Israeli income taxes.
In contrast, a salaried employee working for an Israeli employer and paid via an Israeli pay-slip is not subject to US self-employment tax on their wage income. This is why many Israeli residents prefer to run their business via an Israeli corporation instead of an Israeli sole proprietorship. In this way, they receive wages from the corporation and avoid the double self-employment taxation.
As per article 21 of the US-Israel tax treaty, US social security payments made to a resident of Israel are exempt from US taxation. So even though you may need to pay US social security tax on your Israel-sourced self-employment income, at least when you eventually receive your social security benefit distributions, they are not taxed by the US.
If a US citizen or green card holder is married to a spouse who is neither a citizen nor resident of the US, then the spouse’s income is not required to be reported to the IRS. That being said, one has the option to elect, via section 6013(g) election, to file jointly with the non-US spouse in order to take advantage of a higher standard deduction; in some situations, this can lower the overall tax liability. Another scenario where making this election is tax advantageous is when adding the spouse’s income to the return will increase eligibility for the “Additional Child Tax Credit Refunds” (Form 8812).
The above being said, the election is not advisable in most cases, as the results will often be worse than when filing alone. Once the election is made, all of the spouse’s worldwide income must be reported to the IRS. By not making the election, there exists an option of transferring ownership of income-producing assets to the non-US spouse, thereby decreasing the taxable income reportable to the IRS. Once the election is made, that possibility is lost. For more information see ELECTION TO TREAT NON-RESIDENT ALIEN SPOUSE AS A US RESIDENT (IRC 6013(g))
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