Living and working abroad comes with many exciting benefits. In addition to exploring new lands and learning about new cultures, expats often earn additional income beyond just their regular salary. Foreign earned income can come in many forms. In addition to the wages that are earned, those who are working outside the United States also must declare as income bonuses, tips, commissions, and the like.
It is also common for expats working overseas to have non-cash income as part of their employment package.
This can include housing, meals, use of a car, and various other allowances such as family education benefits for your children and cost of living adjustments. Taken together, these sources form your total foreign earned income.
Form 2555: Show Me The Money!
As you know, US citizens and resident aliens must declare and pay tax on their global income even if they are living in another country. It is possible to reduce your tax liability by completing Form 2555 or Form 2555 EZ. These forms are used to calculate the total amount of money that a person may be eligible to exclude from taxation under the Foreign Earned Income Exclusion and Foreign Housing Exclusion. If you are not claiming the Foreign Housing Exclusion you should use Form 2555 EZ. It is shorter and thus faster to complete. If you intend to take both deductions, you must complete the regular form.
Foreign Earned Income Exclusion (FEIE): This is the amount of income earned from a foreign source that can be excluded from US taxation. It is available to US persons who are living abroad for a specified duration of time during the tax year. The deduction is not automatic; expats must elect to take it.
Foreign Housing Exclusion (FHE): If your housing expenses are paid for using money from your employer, either an allowance or regular income, you may qualify to deduct that amount from your taxable income as well. The maximum amounts vary by country but are generally no more than 30% of the maximum Foreign Earned Income Exclusion for the given tax year.
How Does The Foreign Earned Income Exclusion Work?
When reporting income earned abroad, expats can exclude from their taxable income the amount earned up to the IRS limit, which is adjusted for inflation each year. For the 2017 tax year, the exclusion amount is $102,100. This means that if you make less than that amount you will pay zero in federal taxes. Sweet!
If you make more than the allowed amount, you will pay US federal taxes on the excess. For example, if you make $250,000 this year and qualify for the FEIE your tax owed will be calculated on only $147,000 ($4250,000-$102,100).
The good news is that this applies to people individually, and thus a married couple can claim a deduction up to $204,200 combined.
An important thing to bear in mind is that this exclusion is only for income that was earned abroad. If you have US sourced taxable income it will not be affected by this deduction.
Of course, there are some hurdles that you will need to jump through in order to qualify for the FEIE. First, you must qualify in one of two ways.
1. Physical Presence Test
A person who is physically out of the United States for at least 330 days in any 12 month period. It is not necessary for you to be in the country where you are working during that time. The only requirement is that you are not in the good ol’ U.S. of A. It is common for people in their first year of placement abroad or for those who only intend to be abroad for a limited amount of time to use this calculation to qualify for the FEIE. This is also the choice for digital nomads and others who move around frequently and thus cannot establish a home base.
2. Bona Fide Residency Test
If you obtain legal residence in a new country and intend to stay there for the foreseeable future, the residency test is the way to go. Once you establish the new country as your home base, the place you return to when you travel and where you will establish your family roots you will have much more freedom in the amount of time you can spend in the US (currently up to 4 or 5 months a year).
To help you figure out which test is right for you, we have created this handy tool.
Establishing A Tax Home
In addition to establishing your residency via either the physical presence test or the bona fide residence test, you must also meet the tax home test. A tax home is where you have your principal place of employment or business, even if this is not the same location of your family residence. If you do not have a principal business location, then your tax home is where you reside.
Is Your Foreign Earned Income Working For You?
You work hard. You deserve every benefit afforded by the IRS to keep more of your hard-earned money. By educating yourself on the various tax affordances available to you, such as the Foreign Earned Income Credit, you may be able to hold on to more of what you earn. Don’t let this benefit slip through the cracks. You must complete Form 2555 or Form 2555 EZ and file it along with your return.
Have a question? Contact Olivier Wagner.
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