Tax Obligation for expats living in Israel.
If you are one of the more than 350,000 U.S. expats living in Israel and paying tax to the Israeli government, you are still required to file a U.S. tax return every year, report your worldwide income and pay any tax imposed by U.S. law.
Even though Israel and the United States have a long-standing tax agreement that can help expats avoid paying double taxation, the tax laws differ between the two countries.
The following information is designed to:
- Provide better understanding of IRS tax filing requirements under the agreement.
- Avoid or reduce double taxation on most types of income re: income tax, financial investments, capital gains on investments and household property.
- Types of Israeli investments, that are not recognized by the U.S. and are taxable.
Mandatory Filing
Many expats think that since they already paid taxes to the Israeli government, they do not have to file.
In fact, they must file a 1040 form with the U.S. Internal Revenue Service (IRS) if they earn an annual income of more than U.S. $10,000 ($400 for self-employed) even if they don’t owe any taxes. This includes all worldwide employment income, interest, dividends and capital gains.
Under the treaty with the U.S., Israel shares taxpayer information with the IRS. For example, Israeli banks must report information to the IRS on their U.S. account holders.
If a U.S. expat has an aggregate value of $10,000 or the foreign equivalent in their foreign accounts at any time during the year, they must file an (Foreign Bank Account Report) FBAR. Failure to do so can result in a fine of up to $10,000.
Similarly, they must file the Foreign Account Tax Compliance Act form 8938 on income derived from all worldwide employment income if the net balances in their foreign accounts exceed $200,000 at the end of the year or exceed $300,000 at any time during the year.
Assets in this category include (registered retirement savings plans if they exist in Israel), stock, pensions, annuities, partnership trusts, mutual funds and insurance contracts. This form is required to ensure that the income attributable to these assets is properly reported on the individual’s U.S. 1040 income tax return.
Other Reporting Requirements
The IRS also requires expats to report shares they may have in a Passive Foreign Investment Company on form 8621. This includes owning non U.S. mutual funds. It also includes dividends, interest, rent, royalties, capital gains from the sale of securities.
Persons who have ownership in a foreign corporation may be required to file form 5471.
Avoid Double Taxation
The vast majority of expats living in Israel rarely pay any taxes to the U.S. government, because their tax bill in Israel is higher than it would be in the U.S., cancelling out anything that’s owed in the U.S due to the foreign tax credit.
There are two primary ways to avoid paying taxes to the US on income earned in Israel:
Under the Foreign Earned Income Exclusion (FEIE) one can exclude the first $100,000 or so from U.S. income tax by demonstrating that you qualify for the exclusion either based on the “physical presence test” or the “bona fide residence test”. This does not protect unearned income such as interest, dividends, and capital gains from being taxed.
There is also the Foreign Tax Credit provision which gives you a dollar tax credit for every similar dollar of tax you paid in Israel. Under this procedure, if you pay more tax say in Israel than you owe the U.S., you can carry the excess tax credits forward for future use.
Taxable Under U.S. Law
There is the employer contributions into an Israel pension plan that are not taxable in the year contributed in Israel but are taxable as wages in the US since they do not qualify as a 401k contribution.
Investments in PFIC’s 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, one generally does not get taxed at all on the sale of their principal residence or first home that they are selling in Israel, whereas in the US, one is only able to exclude up to $250,000 of the capital gains on the sale of a principal residence ($500,000 if married filing jointly).
Non U.S. Spouse
If a US citizen or green card holder is married to a Non US citizen who is also not a resident of the USA, then they are not obligated to include their spouse and the related income on their US tax return.
That being said, one can elect to file jointly with their Non US spouse in order to take advantage of a higher standard deduction and additional exemption which can lower the over tax liability in some situations.
Sometimes one may choose to file jointly with their Non US spouse in order to have additional earned income which can help them then be eligible for “Additional Child Tax Credit Refunds” (Form 8812).
However, in cases where the Non US Spouse has a lot of taxable income that will then have to be reported, it is usually advisable to keep them off of the US tax return as the results will often be worse in such situations then filing alone.
The Non-US Spouse can be utilized to lower the US spouse’s income tax liability by shifting some of the assets or income items to the spouse who does not have any US filing obligations.
