If you are an American citizen living in Israel, you are probably already familiar with the bureaucratic burden involved in holding an American passport – the annual reporting of your income to Uncle Sam.
If you are an employee, have some investments in a local bank, and perhaps also own a nice property that yields a few thousand shekels a month, the story probably ends there. However, if you have types of income beyond the aforementioned, in cases where you are self-employed or have investments abroad, you will be required to file a tax return in both Israel and the US.
In such cases, the issue becomes more complex, and it is accompanied by the inevitable question – which return do you file first? In Israel or in the US? And is there concern that due to filing two returns – we will have to pay tax twice?
In this article, we will try to help you understand what exactly you will need to do if you need to file two tax returns, for the US and for Israel, how you will be required to report your income in both returns, which country to file with first, and most importantly – how much tax you will ultimately pay, to whom, and when.
So, Who Takes the First Bite?
To begin answering these questions, we will need to become familiar with one important document, commonly known as the tax treaty between Israel and the US. The Tax Treaty is the agreement that determines how to divide the “tax pie” between the two countries, and how to avoid double taxation.
The Tax Treaty is a rather cumbersome document, full of unclear terms and complex references. However, the idea behind the treaty is quite simple: it determines which country will collect the tax first on each type of income, and how the second country should take into account the tax already paid in the first country.
The treaty stipulates that for every type of income – salary, investments, real estate, interest – there is a “primary right to tax.” The country with this primary right is the one that will collect the tax first. The second country, which does not have a primary right to tax, can also tax the income in many cases, but only on condition that the tax rate applicable in that country to that income is higher than the tax rate applicable to the income in the first country. In such a case, the second country is obligated to grant a credit for the tax already paid in the first country, and collect only the difference.
It is important to note that the treaty also sets maximum tax rates on certain types of income. For example, interest income will be taxed in the US at no more than 15%, given certain conditions. But – and this is an important but – all these benefits do not automatically apply to dual citizens, and sometimes do not apply to them at all.
To summarize this section in one sentence, thanks to the Tax Treaty between Israel and the US, we will almost always pay only the higher tax rate between the two countries, and will not pay tax twice, which is excellent! But we can only do so if we act according to the provisions of the treaty and “divide” our tax pie between Israel and the US correctly. So how is it done?
Employment Income – The Primary Right to Tax Belongs to the Country Where the Work Was Performed
The first type of income we will discuss is employment income. If you worked in Israel, whether as an employee or self-employed, Israel is entitled to collect the tax first on your employment income.
If you think about it, it makes a lot of sense: if the work was performed in Israel, the tax should first and foremost belong to Israel.
For employees, the situation is relatively simple – the Israeli employer deducts the tax for us as part of the monthly payslip, and at the end of the tax year, we will need to attach Form 106 to the American return, and request a credit for the tax already paid in Israel.
In such cases, the IRS will generally not ask us for additional tax, since the tax rate in Israel is usually higher than the US federal tax rate.
Even if you are employed by an American company, receiving a W-2 form from them with tax withheld at source in the US, but all the work was actually done from Israel, you must pay the tax first to Israel. In such a case, you will be asked to report the income included in the W-2 on the Israeli tax return, and pay all relevant tax in Israel without taking into account what was paid in the US. This is because Israel has a primary right to tax the income.
Afterwards, when you file your American tax return, you will state that the income included in the W-2 was generated outside the US, and that full tax was paid on it in Israel, requesting the US refund you for the tax withheld at source on your W-2.
It sounds a bit complicated, but in practice – it’s quite simple, and it’s the correct way to do things. It is worth knowing that in cases like W-2 when the work was physically done from Israel, inefficiency is often encountered regarding social security payments, but that is a topic for another article.
For self-employed individuals, the story is a little more complex. Even if we pay income tax advances in Israel during the year, the final settlement with the tax authorities is only made upon filing the return in Israel and the issuance of the final assessment by the authorities in Israel. In fact, only after we have a final assessment will we know how much tax we actually paid in Israel, and then we can request a tax credit for it on the annual return to the US. If we do not have a final assessment and cannot wait to receive it to file the US tax return, we can ask our accountant for a calculation of the tax we will need to pay in Israel, and use it when filing the US return. Here too there is an issue with social security payments, but as mentioned – we will discuss that in another article.
Dividends and Interest – The Payer Country Determines
When it comes to paying dividends or interest, the story is different. The treaty asks to examine not our place of residence at the time of receiving the income, but the location of the company paying us the money. Again, this makes a lot of sense, and works on the same principle as employment income. The company is located in a certain country and generates income there, which it will distribute as dividends. Therefore, the country where it is located will have the primary right to tax. According to this principle, if the paying company is American, we will need to pay the tax first in the US. If it is Israeli – we will pay first in Israel. Afterwards, if the tax rate in the second country is higher than the tax rate in the first country – we will pay only the difference in the second country.
Let’s take a concrete example:
Suppose you received a dividend from Apple in the amount of $10,000.
Since it is an American company, the US has the primary right to tax the income. Therefore, if the tax rate applicable in the US for the distributed dividend is, for example, 15%, we will need to pay $1,500 in the US on this income. In Israel, assuming the tax rate imposed on dividends is 25%, we will need to file an Israeli tax return to report the dividend income, calculate a tax owed of $2,500, credit the amount paid to the US, and pay an additional 10% ($1,000) to the Israelu tax authorities.
If, instead, the dividend came from Delek (an Israeli company), we would pay all 25 percent to the tax authorities in Israel. Afterwards, we would be required to include the tax we paid in the American return, without paying additional tax in the US. Here too,once again, there are social security issues that we will not touch on for now.
Capital Gains (other than real estate) – Taxing Right Determined by Place of Residence
If you sold shares or made profits from other investments such as digital currencies, the country that will collect the tax first on that capital gain is the country where we reside. In other words, American citizens living in Israel will have to pay the tax first in Israel.
Real Estate – The First Bite Goes to the Country Where the Property is Located
Unlike the incomes discussed so far, such as salary, interest, or dividends, income from a real estate property is much more “local” – it is literally tied to the land. Therefore, regarding real estate income, the treaty sets a simple and clear rule: the country where the property is located is the one that will collect the tax first. It doesn’t matter where we live – what matters is where the property is located.
However, there are differences in how Israel and the US tax real estate income. These differences may lead to us paying tax only in the US, even if Israel was supposed to tax the income first.
Property Sale – Exemption Here, Tax There
There are situations where we can sell an investment property located in Israel and not pay a single shekel of tax to the income tax authorities – for example, if we meet the conditions for the capital gains tax exemption granted for a “single apartment.” However, if we are also American citizens, we may still need to report the sale of the property and pay tax on it in the US.
The reason for this is simple: tax exemptions that exist in Israel are not automatically recognized by the American tax authorities. From the US perspective, if you sold a property and profited from the sale, you will have to pay tax on the profit – just like any other American citizen. If we paid tax in Israel, we would get a credit in the US. However, since nothing was paid here, we may still be liable to pay tax in the US.
It is important to note that certain exemptions also exist in the US regarding real estate sales. However, these exemptions are not identical to those in Israel, but can still impact our final tax payment.
Property Rental – Partial Exemption in Israel, But Not in the US
In Israel, there is an exemption from tax payment and reporting for income from renting a residential apartment up to a certain threshold (approximately 5,400 ILS per month, as of this writing).
However, in this case too, the US does not play by the rules of the Israel Tax Authority and taxes all rental income, even if the rented property is located in Israel.
The calculation of tax payment for rental income is based on net profit – meaning, income from renting the property minus current expenses such as maintenance, insurance, mortgage interest, depreciation, etc. If, after calculating all expenses, there is still a profit, it will be subject to tax in the US, which we didn’t pay taxes for in Israel.
What if I have a salary from Israel, dividends from American companies, and real estate in the US?
Let’s look at Avi as an example: Avi is an Israeli-American citizen. He works at an Israeli high-tech company, invests a bit in the American stock market, puts money in Israeli bonds, and recently bought an investment apartment in Florida.
Perhaps Avi’s case sounds like an extreme example – who has so many types of income? But in reality, many of us have more than one, or two, or three types of income… And the question arises – what should be done in such a case? Which country do you report to first, and where do you pay the tax first?
The sad truth is that there is no single correct answer to these questions – because as we’ve seen, for each type of income, there is a different country that gets to collect the tax first.
Tax on salary – first in Israel.
American dividends – first in the US.
Interest on Israeli bonds – first in Israel.
Real estate in Florida – first in the US.
And this is precisely what is complex in such situations: there is no single report that can “cover all income” before we turn our attention to preparing the second report.
So you might rightly ask: “Okay, but what’s the problem? If I know that the tax on dividends in Israel is 25%, then when I prepare the American report, I’ll just credit this amount.” You might be surprised to learn, or not, that even in the US, the tax rate on passive income has tax brackets. That is, our total income, even if not from passive income, will affect the entire effective tax liability, including passive income. Meaning, I don’t have that flat number that I know I will be using.
Another important thing to understand here is that taxes can only be credited if they were actually paid in another country. Let’s take an example where we received dividends from an American company, which are first subject to tax in the US. Now let’s also assume we have children with American citizenship whom we included in the tax return, and we therefore received tax credits for them that reduced our tax liability to the US to zero.
In such a case, although the US has the primary right to collect the tax, since no tax was actually paid in the US, there will be nothing to credit in Israel. Therefore, in cases where no tax liability is expected (in this example, thanks to child credits), we will not need to wait for the completion of the American tax return to proceed with the Israeli one.
Ultimately, in most cases, the recommendation will be to first file the Israeli tax return and only then the American return. This is because most of our income as residents of Israel is generated in Israel, and also because there may be many cases where we will have enough deductions and credits in the American tax return, so we will not have to actually pay tax in the US.
In more complicated cases, for example, if we have significant income of tens of thousands of dollars from interest or dividends from American companies or real estate in the US, the recommendation will be to prepare both reports simultaneously – the Israeli and the American, not to exhaust or confuse you, but so that you can see the overall tax picture in both countries simultaneously:
- In which country is there an actual tax liability? And for which income?
- What taxes have already been withheld at source before filing the tax return?
- Are there expected tax differences that we will need to complete, and if so – where?
Only after we understand our tax liabilities in both countries, and for what exactly, can we decide what to file first.
Caution – Not All Taxes are Creditable
Although in most cases you can get a credit for tax paid in the other country, there are some types of tax payments that cannot be credited:
- Medicare payment for employees in the US: If you work for an American employer, and receive a W-2 from them with a Medicare payment withheld, this payment will not be allowed as a credit in Israel.
- NIIT – Net Investment Income Tax in the US: In general, the NIIT is a surtax of 3.8%, which applies to passive income (interest, dividends, rental income) when the total income in the tax return exceeds a certain threshold (we wrote about it at length here, feel free to read: LINK).
This payment is also not recognized as a tax payment for which a tax credit can be received in Israel. This means that we will have to pay the NIIT in the US, even if we have already paid tax in Israel on the same income. - State taxes: In the US, in addition to the regular federal tax we know, there is also state tax in certain cases, depending on the relevant state, type of income, place of income generation, and more. In such cases, the crediting capabilities between Israel and the US are not reciprocal, and each case must be examined individually.
So Bottom Line – Where Do You File First?
If you, like most Israelis, are not required to file a tax return in Israel – there’s no question. How wonderful! You start directly with the American return.
If you are still required to file a tax return in Israel, and assuming you live and work in Israel and most of your income is employment income – you should always start with preparing a draft Israeli tax return. If your income types are relatively “simple” – salary/self-employment income from work in Israel, some small investments in stocks – we will finish filing the Israeli return first and receive a final assessment from the Income Tax Authority, which we will rely on to prepare the American tax return.
If you have significant income from interest or dividends from American companies, or if you physically worked from the US or have overseas assets – it is advisable to consult individually, and consider preparing both returns, for Israel and for the US, simultaneously. That is, we will still start with an Israeli draft, but at the end of the preparation process we will not submit the report, but rather print a draft calculation, proceed to prepare the American report based on the prepared draft calculation, and then return to finish the Israeli report based on the prepared American report, taking into account taxes actually paid in the US.
Either way, with a little advance planning and a lot of attention to detail, the process of filing two reports can be made clearer and easier, and most importantly – double taxation can be avoided.