Even if you have left the United States for a brighter future elsewhere, you (something not as strong) take a moment and think about any obligations you have towards the IRS. The US retains its right to tax globally its citizens and resident aliens who are a citizen or national of a country with which the United States has an income tax treaty in effect. Only two countries have such a citizenship-based taxation system: the United States and Eritrea.
What Is A Foreign Earned Income Exclusion For U.S. Expats?
The Foreign Earned Income Exclusion (FEIE) is offered to US citizens and resident aliens that are living abroad on a consistent basis, have earned income in a foreign country and can prove that they have done so for the past tax year by satisfying either the Physical Presence Test or the Bona Fide Residence.
In its great generosity, Uncle Sam allows you to exclude some of the foreign earned income. This amount is $104,100 in 2018 corrected with inflation from $102,100 in 2017, and you would pay taxes on the amount exceeding this threshold. The process takes into consideration the taxes you pay in your adoptive country, which are deducted from your obligations, as long as you satisfy some conditions.
What Counts As A Foreign Earned Income?
It’s important to understand that this exclusion only applies to earned income, not passive income from investments including interest, dividends, IRA distributions or rental income. So, you must either be an employee and get a salary/wage or be self-employed and earn money in the new country.
The IRS gives a few examples of what does not qualify as foreign earned income:
- payment received by working with the U.S. Government or any of its agencies
- pay in some combat zones
- pay for services in international waters
- the value of meals and lodging
- pensions, annuities and social security benefits
- any payment received after the end of the tax year.
For the self-employed, the exclusion only applies to reduce the income tax, not the self-employment tax (15.3% up to $126,000) which covers social security and healthcare insurance. This applies if you earn more than $400. Yet, if you reside in some of the countries listed here you can be exempt even from this through a totalization agreement, but you should earn everything in the same country, so this is not the best news for digital nomads.
How Does A U.S. Expat Qualify For The Exclusion?
You would need a tax home outside the U.S. – this is a given if you otherwise qualify for either test. Then, you must pass one of the two tests.
This is the most widely known test. It requires you to be in a foreign country for 330 days in any 12-month period. These months are counted from any moment of your choice but must be consecutive. Also, the days are required to be full 24-hour days, but not necessarily consecutive. This means that you can visit your relatives both on Easter and Christmas without affecting your tax exemption if you don’t exceed the allowed number of days.
If you spend part of a day either over international water, in the United States (or in Cuba while breaking the embargo), this day wouldn’t count towards the 330 days.
Two exceptions do exist for:
– Being in the U.S. for less than 24 hours while in transit between two foreign countries
– Being in international waters while in transit between two countries
You lose days if you spend more than 24 hours in transit while not being in a foreign country, for example, if you travel by boat in international waters. Be careful when transiting the US, try to keep that under 24 hours, so you don’t lose a day.
The translation of “bona fide” is “in good faith” meaning that you live and work in a foreign country, not just pretend so for tax purposes. You need to ask for this status, as it is not automatically granted if you have been living in a foreign country for more than 1 year. Also, you need to be there with a clear purpose and file for taxes in the foreign country for the entire tax year. If you have already submitted a statement to the foreign state that you are a non-resident, you will not be able to apply for the exemption.
The advantage compared to the physical test is that you can be more relaxed about your trips and days spent away from your new fiscal home if there is a clear and provable intention that you want to return. The disadvantage is that the IRS can deny this claim, based on your specific information.
Paperwork, Tips, and Tricks
To get the FEIE, you need to file Form 2555 (or Form 2555-EZ if you don’t also claim the housing deduction). By filling in one of these forms, you can request the deduction up to $102,100. If you had earned more, the difference would be taxed according to the corresponding tax bracket of the entire amount, not just the difference.
In the case of self-employed, you can just cap your salary at the limit and keep the rest as retained earnings.
If you are married, each of you can get a deduction of $102,100 as long as you both qualify, through either of the described tests. If just one of you is eligible, you can still file jointly and only ask for one deduction.
We advise you to carefully consider your particular situation and educate yourself about deductions and tax opportunities as these could reduce your obligations significantly or erase them completely.
Have a question? Contact Olivier Wagner.
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