Even if you’ve moved abroad for a brighter future, you still might have obligations towards the IRS. What happens if you earn income from sources outside the United States? If you live abroad, you might qualify for the foreign earned income exclusion (FEIE). This article explains what FEIE is and how it works, and provides some examples of situations where you might benefit from claiming it.
The U.S. retains its right to tax citizens and Green Card holders who live abroad and they must file their taxes even if they’re not physically present in the country. The foreign earned income exclusion (FEIE) allows U.S. taxpayers to exclude from their taxable income certain amounts they earn outside the United States. The FEIE was created in 1954 to relive American Citizens from the burden of double taxation when they move overseas.
What is the Foreign Earned Income Exclusion?
The Foreign Earned Income Exclusion is an IRS exclusion that American expats can use to reduce their taxable income (or in some cases completely eliminate) i.e. their U.S. tax owing. It is the most common and the most widely used tool to reduce US expat tax owing that the IRS offers.
You don’t automatically receive the benefit of FEIE by just living abroad — you must meet specific qualifications which we will discuss later and submit the Form 2555.
How Much Foreign Earned Income Can You Exclude?
U.S. citizens and resident aliens who meet certain requirements to exclude up to $108,700 of foreign earned income in 2021 (The FEIE is adjusted every year for inflation). If used correctly, the FEIE can help you save thousands of dollars on your US taxes.
The maximum exclusion for 2022 is $112,000. If you’re filing under the married filing jointly status and your spouse also meets the FEIE requirements, you can exclude up to $224,000of your foreign income in 2022.
What Counts as a Foreign Earned Income?
It’s important to understand that this exclusion only applies to foreign and earned income. Earned income includes wages, salaries, professional charges, or other amounts paid to you for personal services rendered.
You cannot exclude income you earned while working in the US or passive category income such as distribution of earnings or profits, dividends, interest, rental income and/or IRA distributions. You must either be an employee and get a salary/wage or be self-employed and earn money in the new country.
1) The IRS gives a few examples of what does not qualify as foreign earned income:
- payment received as a employee the U.S. Government or any of its agencies
- pay as millitary personel in combat zones
- pay for work performed on international waters
- the value of meals and lodging
- pensions, annuities and social security benefits
- any payment received after the December 31st of the tax year.
2) Foreign Earned Income Exclusion and Self-Employment Income. The exclusion will only reduce your income tax, but it will not lessen the self-employment tax assessted on your foreign income (unless, you live in a country with a totalization agreement). You can find the list of countries with a totalization agreement here. The self-employment tax amounts to 15.3% of your income.
Who qualifies for the Foreign Earned Income Exclusion?
In order to qualify for the Foreign Earned Income Exclusion, you must have foreign earned income, a tax home outside the United States, and meet either the Physical Presence Test or the Bona Fide Residence Test.
The Physical Presence Test
You meet the physical presence test if you are physically present in a foreign country or countries for minimum 330 full days during any 12-months. These months are counted from any moment of your choice and they must be consecutive.
The test is based soley on how much time you spend in foreign country or countries. Most of US expats claim the exact calendar year (i.e. US tax year). The days are required to be full 24-hour days, but they don’t need to be necessarily consecutive. This means that you can visit your relatives both on Easter and Christmas! It will not affect your FEIE, if you don’t exceed the allowed number of days.
If the period for the FEIE includes only part of the tax year, you must adjust your maximum exclusion limit based on the total number of qualifying days in that tax year.
If you spend part of a day either over international water or 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 for 25 hours. Be careful when transiting through the US – try to keep that under 24 hours, so you don’t lose a day!
The Physical Presence Test is a perfect tool for digital nomads who are moving from country to country or who can’t prove permanent residency in any foreign country. It requires expats to limit and track their time spent in the US and to ensure they spend at most 330 full 24-hour days outside the US.
The Bona Fide Residence Test
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.
Under Section 911(d)(1), “bona fide residence” means:
“(A) Residence in a foreign country which constitutes a permanent home; and (B) an intention to reside permanently in such foreign country
You’re not limited to spending 35 days in the US. You meet the bona fide residence test if you are a resident of a foreign country for an uninterrupted period that includes a full tax year. You may leave your foreign residence for brief or temporary trips to the United States or another foreign country as long as you clearly intend to return to your foreign country of residence.
Note: You do not automatically become a Bona Fide Resident by living in a foreign country for one year.
Whether you are a Bona Fide Resident is determined by your personal circumstances and that includes factors such as your intentions or purposes for being in the foreign county, your activities in the country, and whether you payed taxes to the country. In case of audit, you must be able to prove you have no intention of coming back to the US any time soon. If you have already submitted a statement to the foreign state that you are a non-resident, you will not be able to pass this test.
The advantage of the Bona Fide Residence test compared to the Physical Presence test is you can be more relaxed about your trips to the Unites States and days spent away from your home (as long as 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.
The Foreign Housing Exclusion
If the foreign earn income exclusion doesn’t bring your taxable income down to zero, you can claim the foreign housing exclusion. The amount of qualified housing expenses elibible for the exclusion is subject to limitation. It is generally 30% of the maximum foreign earned income exclusion.
The general housing exclusion limitation for 2021 is $32,610 (30% of $108,700). However, the limit might vary depending in the location of your foreign tax home and the number of qualifying days in the tax year. For example, if you live in Singapore, your housing exclusion limitation is $84,700. You can find the adjusted limitations on housing expenses here.
American Expats can claim the Foreign Housing Exclusion on the same form they use to claim the FEIE – IRS Form 2555, Section V and VI.
How to claim the Foreign Earned Income Exclusion?
You need to complete Form 2555 (or Form 2555-EZ if you don’t claim the housing deduction) and file it with your form 1040. It will allow you to exclude up to $108,700 of your foreign earned income from your taxable income. If you had earned more, the difference would be taxed according to the corresponding tax bracket of the entire amount, not just the difference.
Although the Form 2555 doesn’t seem to be very complicated, we realized that there are many misconceptions and there’s a plenty of room for errors while compliting this form. We suggest that expatriates with any queries or doubts contact an experienced and reputable expat tax preparation specialist so that they don’ t make any expensive mistakes.
Part I asks for personal details such as foreign address, employer’s details and where your tax home is. If you meet the Bona Fide Residence test, you should complete Part II. Part III is dedicated to the Physical Presence Test. You only need to meet one of the test.
The next part is where you claim your foreign earned income to be excluded. If you claim the foreign housing exclusion/deduction, complete the Part V and VI. If you are married filing jointly, each of you can get a deduction of $108,700 as long as you both qualify for FEIE. If just one of you is eligible, you can still file jointly and only ask for one deduction.
Most common mistakes while claiming the FEIE
One of the most common misconceptions about the Foreign Earned Income Exclusion is that you don’t need to report the foreign salary on your federal tax return or that the FEIE is applied automatically. Moreover, many US expats believe they do not need to file a tax return if their earnings do not exceed the FEIE limit.
The exclusion applies only if a qualifying individual with foreign salary who meets all of the requirements claims the FEIE on forms 2555 and reports it on his tax return.
What is the difference between the Foreign Tax Credit or the Foreign Earned Income Exclusion?
It is important to consider your entire tax situation when deciding between the Foreign Tax Credit (FTC) and the Foreign Earned Income Exclusion (FEIE). Claiming the Foreign Earned Income Exclusion will bring your taxable income to zero, when you live in countries with no income tax such as Singapore or UEA.
However, the FEIE comes with disadvantages. You won’t be able to contribute to your individual retirement plan (IRA), be eligible for the additional child tax credit (even if you have a qualifying child) or reduce your income tax liability on your investment income.
Furthermore, if you revoke the exemption, you cannot claim it again for five years. The only way to claim the exemption again requires a costly process with the Internal Revenue Service. An expat tax advisor can assist you in understanding your options.
Claiming the foreign tax credit and filing Form 1116 on the other hand, might be the better option if you’re paying more tax to your foreign country of residence than you would to the US. You would be eligible for the additional child tax credit (if your child is a qualifying child), contribute to your IRA and offset your US tax liability on your investment income.
Can I claim both the Foreign Earned Income Exclusion and the Foreign Tax Credit?
Yes, you can claim both the Foreign Tax Credit and the Foreign Earned Income Exclusion. However, you cannot use the foreign tax credit attributable to the earned income you excluded using the FEIE.
We recommend that you carefully consider your particular circumstances and seek professional advice.
Have a question? Contact Olivier Wagner.
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