PFIC: why your foreign mutual fund is a US tax problem

A local bank in Madrid, Singapore, or São Paulo sells you a perfectly ordinary fund. For US tax purposes it is a passive foreign investment company, and it is taxed on terms designed to make holding it unattractive.

A foreign corporation is a PFIC if 75% or more of its income is passive, or 50% or more of its assets produce passive income. Nearly every non US mutual fund, UCITS, ETF, and many insurance wrapped investment products meet one of those tests. There is no minimum holding, a single share counts.

Without an election, gains and excess distributions are allocated across your holding period, taxed at the highest ordinary rate in force for each year, no long term capital gains treatment, and then charged interest as though the tax had been underpaid all along.

• QEF: taxes you annually on your share of the fund's ordinary earnings and capital gain, at normal rates. It requires an annual information statement that most non US funds do not produce.
• Mark to market: available for marketable stock, taxes annual appreciation as ordinary income and allows limited losses. Simpler, and usually the realistic option.

Both are most effective made in the first year of ownership. Made later, a purging election may be needed to clear the accumulated regime, and that has a cost of its own.

For most Americans abroad, the cheapest fix is not an election but a portfolio that does not contain PFICs: direct holdings, US domiciled funds where accessible, or vehicles reviewed before purchase. For someone moving to the US, selling PFIC holdings before the residency start date removes the problem entirely.