Foreign Income Exclusion – One Of The Most Spectacular Tax Benefits For Overseas Income Earners
If you live and work in a foreign country and had foreign earned income or self-employment income earned while overseas you may qualify for the foreign income exclusion , foreign housing exclusion or the foreign housing deduction, if you meet certain requirements.
This is quite the significant tax benefit in light of the fact that the U.S. tax system is a citizenship-based vs. resident-based tax code.
Why is this such a tremendous benefit? If you are a U.S. citizen or a resident alien of the United States and you live abroad, you are taxed on your worldwide income irrespective of your residency or tax treatment or residency classification from other foreign countries.
However, you may qualify to exclude from income up to an amount of your foreign earnings that is adjusted annually for inflation ($100,800 for 2015). In other words, this income is excluded from federal taxation.
It should be noted that some state income taxes by design share in this benefit, but others do not.
For purposes of the foreign earned income exclusion, the foreign housing exclusion, and the foreign housing deduction, foreign earned income does not include any amounts paid by the United States or any of its agencies to its employees.
So, if you work for the U.S. State Department in the United Arab Emirates your income is not considered “foreign earned income” for purposes of the foreign income exclusion.
What Is Foreign Earned Income?
As mentioned previously, the foreign income exclusion applies only to income arising from performing services either as an employee or as an independent contractor.
“Foreign earned income” means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered.
Thus, wages and self-employment income may qualify for the foreign earned income exclusion.
Other types of income cannot be excluded using this provision, such as passive income, which commonly includes interest, dividends, capital gains, etc.
How To Qualify For The Foreign Income Exclusion
To qualify for the foreign income exclusion, a person needs to:
- Have foreign earned income,
- Must have a tax home in a foreign country and
- Meet either the Bona Fide Resident Test or Physical Presence Test
How Does The Foreign Income Exclusion Impact Tax Rates?
Taxpayers claiming the foreign income exclusion will pay tax at the tax rates that would have applied had they not claimed the exclusion.
In other words, the federal income tax is calculated by first calculating the amount of income tax on income without taking the foreign earned income exclusion into account, and then subtracting the tax as calculated on the amount of foreign earned income that is excluded.
The result is the amount of the federal income tax liability. To facilitate this calculation, taxpayers use the Foreign Earned Income Tax Worksheet, found in the Instructions for the Form 1040.
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