The most common issues that make dual-status citizens living in Israel owe U.S. tax
Our clients are always in a rush to file their U.S. taxes and get a refund for their children. However, once we tell them that instead of getting thousands back from the U.S. government, there is actually a tax liability, they reassess holding on to their U.S. citizenship. Very often, these taxes are avoidable when they plan properly and provide advance notification to their tax preparer ahead of any big decisions like selling a house. They often don’t know what to discuss with their CPA beforehand, and really, who can expect them to? With that in mind, let’s discuss some of the tax mistakes to avoid for dual citizens living in Israel that you and all U.S. citizens should be aware of:
- Atzmai work – self-employment income
- Passive investments (PFICs, and Obamacare taxes)
- Rental income
- Sale of a house/apartment
- Pension contributions and distributions
- Disability tax deductions in Israel
- RSUs & Options
- Companies and GILTI/Subpart F
As most know, the U.S. and Israel have a tax treaty to protect against double taxation. This helps dual citizens immensely because otherwise, they could be paying taxes on their Israeli salary and wouldn’t receive those nice child refunds. However, those that have an osek murshe or osek patur are caught in a big U.S. tax trap. The U.S.-Israel treaty is only an income tax treaty and is not in place to protect against double taxation of Israeli bituach leumi and U.S. self-employment tax. The Social Security (also referred to as self-employment tax) rules exempt employees of Israeli companies, but not self-employed U.S. citizens residing in Israel. Therefore, if you are self-employed in Israel, you can end up paying Israeli income tax (up to 50%), bituach leumi (around 15%), and U.S. self-employment tax (around 15.% on your net income). This creates a heavy tax burden on people trying to live off their hard work. There are ways to protect against this and we encourage you to speak to one of our associates if you are in this situation.
It should be noted that there is a silver lining with paying social security. If you pay in enough (40 quarters), you can get benefits later in life that are tax-free in both countries. This has its caveats and nuances, though, so be sure to be in touch with us about it.
Starting with the 2013 tax year, President Obama instituted the NIIT (Net Investment Income Tax) otherwise called the Obamacare tax of 3.8%. Similar to self-employment tax, this tax is separate from your regular income tax and can affect you regardless of the amount of Israeli taxes you pay. You will generally owe NIIT tax if your overall income is over certain thresholds and you have passive income. As an example, say you are filing jointly with your U.S. spouse, and you have a combined salary of $200,000 and capital gains from your Israeli bank account of $75,000. The NIIT threshold for couples filing together is $250,000 so you will owe 3.8% U.S. tax on the $25,000 difference (200K+75K=275K-250K=25K). Since this tax only applies to passive income, it is important to note that even if you have a salary of $2M as your sole income, the NIIT of 3.8% will not apply to you.
There is another aspect of passive investments that can cause a big U.S. tax headache. Namely, passive foreign investment companies or PFICs. These generally include non-U.S. kranot neemanut, kranot sal, ETFs, kupot gemel (not funded by your employer), hedge funds, mutual funds, and some start-ups. Generally, if the return on investment looks good, it is likely a PFIC and may cause heavy U.S. taxes. For U.S. tax purposes, you may not only have a requirement to file reports on each PFIC you hold but upon sale, the U.S. can tax them at very high marginal tax rates plus interest. Another negative aspect of PFICs, which sometimes may be worse than the high U.S. tax, is that the gains cannot be offset by other PFIC or capital losses
Similar to the other items here, with proper planning and U.S. tax advice beforehand, much can be done to avoid these tax pitfalls.
Israel is always trying to bring down rental prices and their main way of doing so is by giving tax incentives to lower rental income. Unfortunately, Israeli rental tax discounts do not carry over to the U.S. tax system. The U.S. tax rate on rental income can be as high as 37% (and the NIIT mentioned above can apply). In Israel, if you are paying a flat 10% on the gross rental income, you may end up with some remaining U.S. income tax on the rental. Additionally, if the Israeli tax is zero because the rental income is around 5,000NIS there is a good chance you will end up owing some U.S. tax. One easy way to avoid this tax is to gift the property to your non-U.S. spouse. The number of times we have had to tell clients that they owe tax because they own property jointly or on their own names instead of their non-U.S. spouse’s is more than I would like to count. Often, Israel will let you gift property between spouses tax-free, but it needs to be done in time to protect against U.S. taxes. There are other ways to counter tax on rental income, so please be in touch with us if you have Israeli rentals.
Selling Your Primary Residence in Israel
Remaining with a similar theme as the rental income, Israel will often not tax the gain from the sale of your primary residence in Israel. Also, in some cases, the U.S. will permit a tax reduction if the location sold was your primary residence. However, with the Israeli real estate markets growing as they are, the U.S. tax exclusion is often not enough. Additionally, Israel often allows tax exemptions on sales that do not qualify for U.S. tax relief. As with the above, the Net Investment Income Tax of 3.8% may also cause large U.S. taxes, even with the Israeli taxes paid. It is crucial to speak to us before you sell any property to see if we can help you avoid unnecessary U.S. taxes.
If you are looking to withdraw money from your Israeli pension, there may be U.S. tax consequences to consider. Very often Israel will not tax them, like in the case of keren hishtalmut, and the U.S. will. Other times Israel may not be taxing them enough to cover the U.S. tax due. By coordinating the timing of your withdrawals, you can take advantage of big tax savings. Please speak to your associate beforehand, so they can help plan out the best way ahead.
Additionally, some kupot gemel options like meah tishim, may have negative U.S. tax effects when contributions are made. Make sure to speak to us before you open any new kupot gemel or pension funds.
Disability tax deductions:
This may be one of the worst areas, and there isn’t much to do other than be aware of it. For U.S. tax purposes, if you are elderly or legally blind, you receive a slightly higher standard deduction. This benefit does not amount to much and is nothing compared to Israeli tax savings. In Israel, there are a number of benefits available to those suffering from numerous hardships. Be aware that if you or someone you love has U.S. citizenship and pays lower taxes in Israel because of a disability, they likely will have to pay additional U.S. taxes.
RSUs & Options:
Most high-tech firms now like to offer equity incentives to their employees. This is a great way to share in the growth of the company. For Israeli purposes, these are often done under a 102 plan and can offer big tax savings. Following the common theme of this article, the U.S. works completely differently and the timing of the tax event and tax rate both can differ for the U.S. Additionally, if your company gives you options that cost less than the current fair market value, there could be additional U.S. tax issues to take into account.
Please make sure to bring these offerings up with us, so we can help you make the right decisions with all sides taken into account. Our team is uniquely skilled in the area of equity options and can help you make the right choices to capitalize on a big exit in the future.
Company holdings (GILTI & Subpart F):
One of the best solutions to avoid paying self-employment taxes in the U.S is to incorporate in Israel. However, this has its own set of issues to be aware of. The U.S. has two sets of rules that may cause you to owe personal taxes on your Israeli company income. While you may be allowed a credit on taxes paid in Israel, Global low taxed income & Subpart F income may create a timing issue between the tax paid in Israel and the U.S., resulting in double taxation. We have written in-depth on the topic of GILTI tax and are top experts in the field.
While the above topics cover some of the more common issues that can arise for dual-status citizens, there are always more to be aware of. I would advise erring on the side of caution. If you are unsure if your U.S. CPA should be aware of an upcoming income event, assume yes. It never hurts to reach out to us with your questions; we are always happy to hear from you and connect. The more you share, the more we can advise. We look forward to many years of success with you and are always available to offer assistance in whatever way we can.