*The net investment income tax was written with frozen thresholds and placed beyond the reach of the foreign tax credit, and most Americans abroad discover all three of those design choices at once.*

Panama City, Day 16. I am writing this from a dollarized economy with a territorial tax system, which is exactly the kind of place where an American can be forgiven for thinking their US tax exposure has gotten simpler. For wages, it often has. For a portfolio, there is a 3.8 percent tax that made the trip with you, and the way it is built catches more expats every year.

Here is the shape of the problem in one paragraph. The net investment income tax, NIIT, is a 3.8 percent federal tax on investment income: dividends, interest, capital gains, rental income, royalties. It applies once your modified adjusted gross income crosses $200,000 as a single filer or $250,000 married filing jointly. Those thresholds were set in 2013 and have never been adjusted for inflation. The foreign earned income exclusion does not shield investment income from it. The income you excluded gets added back when the IRS tests whether you crossed the threshold. And the foreign tax credit, the standard defense against being taxed twice on the same income, cannot legally offset it under current IRS rules. Each of those sentences is a separate design choice, and they stack.

The assumption that gets people

Most Americans planning a move abroad have absorbed a rough model of expat taxation that goes like this: the US taxes citizens on worldwide income, but between the foreign earned income exclusion and the foreign tax credit, you will not actually pay twice on the same money. File the forms, claim the exclusion or the credit, and double taxation is mostly a paperwork problem.

That model is roughly right for salary. It fails for investment income, and it fails in a way the standard model does not predict.

The foreign earned income exclusion, $132,900 for 2026, applies only to earned income: wages, salary, self-employment income. Dividends from your brokerage account, interest on your savings, the gain when you sell appreciated shares, the rent from the condo you kept: none of that is earned income, and none of it is excludable. This part surprises fewer people. The parts that follow surprise almost everyone.

The add-back, the freeze, and the chapter

The threshold test is where the first trap sits. For NIIT purposes, modified adjusted gross income is your AGI increased by the amount you excluded under the foreign earned income exclusion, with adjustments for the deductions attributable to it. In plain terms: the exclusion that removed your salary from your taxable income gets reversed for this one test.

Run the numbers on a common profile. A single remote worker abroad earns a $150,000 salary and excludes $132,900 of it. Her return shows modest adjusted gross income. She also realizes $80,000 in long-term gains rebalancing a portfolio she has held for a decade. For the NIIT test, the excluded salary comes back: her modified AGI lands around $230,000, which is $30,000 over the single-filer line. The tax applies to the lesser of her net investment income or the amount over the threshold, so she owes 3.8 percent of $30,000, about $1,140. Nothing about her situation looks like the picture the phrase “high earner surtax” puts in your head. The add-back put her there.

The second design choice widens the net every year. The $200,000 and $250,000 thresholds are not indexed for inflation. They were set in 2013 and they have not moved. Thirteen years of wage growth and portfolio growth later, income levels that were comfortably below the line when the statute was written now cross it routinely. A threshold that does not move in an economy where nominal incomes do move is a tax increase on a schedule, no vote required. With US inflation running at 4.2 percent for the year through May, the real value of that frozen threshold is eroding faster than usual right now.

The third design choice is the one that specifically punishes living abroad. The normal answer to double taxation is the foreign tax credit: you pay tax to your country of residence, and the US credits that tax against your US liability on the same income. But the statute that grants the credit applies it against taxes imposed under chapter 1 of the Internal Revenue Code. Congress placed the NIIT in chapter 2A. Under the IRS reading, the credit simply cannot reach it. So an American in a high-tax country can pay full local tax on dividends and then pay the 3.8 percent again to the US, with no offset, because of where a section number sits in the code.

The treaty fight, and why you cannot rely on it yet

If the chapter placement sounds like the kind of thing a tax treaty should override, you are thinking along the same lines as two sets of taxpayers who took the question to court.

In Christensen, decided by the Court of Federal Claims in October 2023, a couple resident in France argued that the double-taxation article of the US-France treaty independently entitled them to credit French taxes against the NIIT, regardless of the chapter placement. They won. In Bruyea, decided in December 2024, the same court reached the same conclusion under the US-Canada treaty. Two rulings, two treaties, same principle: the treaty promise of relief from double taxation can reach a tax the domestic credit rules cannot.

Both cases are on appeal at the Federal Circuit. Until the appeals resolve, the IRS position has not changed, and it is likely to reject refund claims taking the treaty position in the meantime. Some taxpayers in treaty countries are filing protective refund claims to keep open tax years alive in case the rulings hold. That is a conversation to have with whoever prepares your return, and it only matters if you live in a country whose treaty has the relevant double-taxation language. What nobody should do is plan a move assuming the treaty position wins. Plan under the rules as enforced; treat a favorable appellate outcome as upside.

What someone who understands this does differently

The sequence matters more than any single move.

First, know your number before you move, not after. The threshold test runs on modified AGI with the add-back, so compute it the way the IRS will: salary including what you plan to exclude, plus every category of investment income you expect to realize. If the total sits near $200,000 single or $250,000 married, the timing of gains becomes a planning variable you control.

Second, treat large realizations as schedulable events. The NIIT applies to the lesser of net investment income or the excess over the threshold, which means gains you can time, a rebalancing, a property sale, a concentrated position you finally unwind, can sometimes be spread across tax years to stay under or barely over the line instead of far over it in a single year. The difference is not subtle: realizing $120,000 of gains in one year versus $60,000 across each of two years can change the NIIT bill materially depending on where your other income puts you.

Third, if you are moving to a treaty country with local tax on investment income, price the NIIT into your comparison honestly. A country’s headline dividend rate is not your all-in rate if the 3.8 percent stacks on top with no credit. Two destinations that look similar on local tax can diverge once you add the US layer, and territorial-tax countries like the one I am sitting in change the math again, because with no local tax on foreign-source investment income, the NIIT may be the only layer, which is a very different situation from paying it as a second layer.

Fourth, if you already live in a treaty country and have paid NIIT on top of local tax in open years, ask a professional about the protective claim question now, before the statute of limitations closes those years, not after the Federal Circuit rules.

Who is most exposed

The profile that walks into this tax is not the one the word “surtax” suggests. It is the mid-career remote worker whose salary plus a good market year crosses the line only because of the add-back. It is the retiree abroad living on dividends and a pension whose portfolio finally grew into the frozen threshold. It is the expat who sells a rental property in a single tax year and discovers the entire gain counts. It is anyone in a high-tax treaty country paying full local rates and assuming, reasonably but wrongly, that the credit system prevents a second US bill on the same income.

The window for acting is almost always before the tax year in which the income lands. Once a gain is realized, the planning conversation becomes an accounting conversation. And every year the thresholds stay frozen while incomes inflate, the population this applies to quietly grows.

Key takeaways

The NIIT is 3.8 percent on investment income above $200,000 single or $250,000 married, and those thresholds have been frozen since 2013. The foreign earned income exclusion does not shield investment income, and the excluded amount is added back when testing whether you cross the threshold. The foreign tax credit cannot offset the NIIT under current IRS rules because of the tax’s placement in chapter 2A of the code. Court rulings under the France and Canada treaties have allowed treaty-based credits, but both are on appeal and the IRS position stands for now. Timing realizations around the threshold, pricing the 3.8 percent into destination comparisons, and asking about protective claims in treaty countries are the practical levers.

If you are not sure whether this applies to your situation, one session can get you to clarity before the return does it for you. A single relocation and financial consultation walks through your specific income mix, your destination’s treaty status, and the timing levers you still control. Book Here! Brightshadow2k.com (http://brightshadow2k.com)

BrightShadow | Substack Article | 2026-07-12

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Originally published on Substack (https://brightshadow2k.substack.com/p/the-38-percent-tax-that-follows-your).