FAQs - Foreign Earned Income Exclusion

Self-employed taxpayers must pay self-employment tax on their net business income based on the IRS’ current rates, unless you are in a country with a Totalization Agreement. For 2017, the Social Security tax rate is 6.2 percent of the first $127,000 you earn during the year. If you’re self-employed, this means you must pay a 12.4 percent Social Security tax (consisting of payments both as an employee and employer). The Medicare tax rate for 2017 is 1.45 percent, so self-employed taxpayers must pay a 2.9 percent tax. This tax applies to all of the income you earn during the year. You will need to pay estimated self-employment taxes on a quarterly basis to avoid interest and penalties.

An individual’s tax on any foreign earned income above the exclusion amount is computed as if the foreign earned income exclusion was not claimed. The individual’s tax will be the excess of the tax that would be imposed if his or her taxable income were increased by the amount(s) excluded, and the tax that would be imposed if his or her taxable income were equal to the excluded amount(s). For this purpose, the excluded amount(s) will be reduced by the aggregate amount of any deductions or other exclusions otherwise disallowed.  The tax rate is based on both excluded and non-excluded income.

In addition to the foreign earned income exclusion, you can also claim an exclusion or a deduction from gross income for your housing amount if your tax home is in a foreign country and you qualify for the exclusions and deduction under either the bona fide residence test or the physical presence test.

The housing exclusion applies only to amounts considered paid for with employer-provided amounts, which includes any amounts paid to you or paid or incurred on your behalf by your employer, which must be taxable foreign earned income to you for the year (without regard to the foreign earned income exclusion). The housing deduction applies only to amounts paid for with self-employment earnings.

Your housing expenses may not exceed a certain limit. The limit on housing expenses varies, depending upon the location in which you incur housing expenses. The limit on housing expenses is computed using the worksheet on page 3 of the Instructions for Form 2555.

Certain taxpayers may be able to exclude employer-provided housing amounts and deduct housing costs not provided by the employer. The exclusion is limited to the extent that it exceeds 16 percent of the maximum exclusion. Qualified housing expenses include:

• Rent
• The fair rental value of housing provided in kind by your employer
• Repairs
• Utilities (other than telephone charges)
• Real and personal property insurance
• Nondeductible occupancy taxes
• Nonrefundable fees for securing a leasehold
• Rental of furniture and accessories
• Residential parking

Qualified expenses do not include deductible interest and taxes, housing expenses claimed on Form 8829, the principal portion of your mortgage payment, furniture purchases, capital improvements or the cost of domestic labor.

When choosing between the foreign earned income exclusion and foreign tax credit, it is an easy choice to use the credit only if you didn’t earn any wages and received only retirement income. On the other hand, if you didn’t pay any taxes to your foreign country and you did earn income, the exclusion is the better choice. Further, depending on your income and the rate of tax in your resident country, it may make more sense to use a combination of the exclusion and credit; then again, it may not. Either way, a proper analysis and comparison are recommended to determine what is most beneficial for the current tax year (but also prospectively for future years).

 

To qualify for the exclusion, you must be either a bona fide resident of a foreign country or be physically present in the foreign country for 330 full days during any 12 consecutive months. The 330 days do not need to be consecutive. A full day in any foreign country counts. If you qualify for the exclusion and a portion of your physical presence period is during the previous or following calendar year, the exclusion is prorated:

(“Number of days in your qualifying period that fall within the calendar tax year” / “Number of days in the calendar tax year”)  X  Maximum foreign earned income exclusion

The U.S. is the only country that has taxation of worldwide income for all of its citizens, no matter where they live and regardless of how long they have been overseas. In fact, the U.S. is one of the the only countries that imposes what is known as a “diaspora tax” on its citizens.

If you are a U.S. citizen or a resident alien, the rules for filing income, estate and gift tax returns, along with paying estimated tax, are generally the same, whether you are in the United States or abroad. With taxation of worldwide income, your U.S. and foreign income is subject to U.S. income tax, regardless of where you reside. It is a citizenship-based income tax.

 

The “foreign earned income exclusion” is strictly based on “foreign earned income” only (i.e. foreign wages or self-employment income). Passive income, such as interest, dividends, capital gains and retirement distributions, are not considered “earned income.”

Unfortunately, income from working abroad as an employee of the U.S. Government does not qualify for either the exclusions or the housing deduction. If you paid foreign income taxes, it is likely that you will qualify for the Foreign Tax Credit that can be used to offset double taxation. More information about the foreign tax credit can be read here:

https://taxsamaritan.com/tax-preparation-services/expatriate-tax-services/foreign-tax-credit/