As an expat, one of your biggest tax concerns will surround the possibility of owing taxes to the United States for the money you earn in another country. Fortunately, the United States offers several tax benefits that you can use to reduce and/or eliminate any liability you may have. One of the biggest advantages available to you as someone earning money overseas is the Foreign Earned Income Exclusion. This advantage is available to most expats, with the exception of U.S. government employees.
Do U.S. Citizens Pay Taxes on Foreign Income?
Unlike most other countries, the United States requires its citizens to report and pay taxes on all of the income they earn during the year, including income from other countries. Some people living and working outside of the United States are unaware of this requirement, but lack of awareness will not excuse your tax liability or responsibility to file a return. Fortunately, many people who earn income overseas are able to reduce the amount of tax they owe to the United States using certain available tax benefits, such as the Foreign Earned Income Exclusion, Foreign Tax Credit, Foreign Housing Deduction and more.
What Is the Foreign Earned Income Exclusion?
The Foreign Earned Income Exclusion, or FEIE, is a tax benefit that allows you to exclude income earned in a foreign country from your taxable income for U.S. purposes. If you meet the requirements established by the Internal Revenue Service for a given tax year, you will be able to deduct some or all of the income you have earned outside of the United States during that tax year. The limit on this deduction changes on an annual basis to reflect inflation. Qualifying for the Foreign Earned Income Exclusion typically means that you qualify for the Foreign Housing Deduction as well.
Foreign Earned Income Exclusion versus Foreign Tax Credit
The Foreign Earned Income Exclusion and the Foreign Tax Credit are two of the most popular tax advantages available to expats. However, they are not the same. The Foreign Earned Income Exclusion allows you to exclude a certain amount from your U.S. taxable income, which lowers the total amount of income on which tax will be calculated. The Foreign Tax Credit, on the other hand, reduces the tax you owe to the United States dollar-for-dollar based on the amount you have already paid to a foreign country.
It is important for expat taxpayers to remember that you cannot claim both of these benefits for the same income. For example, if you exclude all of your foreign earned income using the Foreign Earned Income Exclusion, you cannot use any taxes you paid on that excluded income to qualify for the Foreign Tax Credit. However, it is possible to claim both of these benefits by allocating a portion of your qualifying foreign income to each. An expat tax professional can help you determine the best way to use these tax benefits to your advantage
Can I Reduce My Taxes With The Foreign Earned Income Exclusion (Form 2555)?
Yes, it is possible. 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 and as such must file a U.S. return for all the years that you are residing abroad. However, as a U.S. expat you may be able to use the foreign earned income exclusion to reduce the taxes you owe or eliminate your taxable earned income altogether.
What Are the Requirements for the Foreign Earned Income Exclusion?
In order to be eligible for the foreign income exclusion, an expatriate must meet all four of the following requirements:
- Must have foreign earned income
- Must have a tax home in a foreign country
- Must meet either the bona fide residence test or physical presence test
- Make a valid election to exclude foreign earned income
Foreign Earned Income
The foreign earned income exclusion is only available for wages or self-employment income earned for services performed outside the U.S. Foreign “Earned” income includes salaries, wages, commissions, bonuses, self-employment income. In addition, the income must be “foreign” earned meaning that the services were performed in a foreign country.
It does not include:
- Non-earned income or passive income such as investment income (interest, dividends and capital gains), social security
- Income earned as an employee of the U.S. government
- Income for services performed in international waters
- Self-employment taxes; while you can exclude your self-employment income, your self-employment income is subject to self-employment taxes (social security and medicare taxes) unless the services were performed in a country that has a totalization agreement with the United States.
Tax Home in a Foreign Country
Another requirement you must meet before you can qualify for the Foreign Earned Income Exclusion is having your tax home in a foreign country. Your tax home must be in a foreign country throughout the entire period you use to meet the requirements of the physical presence or bona fide residence test.
Defining “Tax Home”
According to the Internal Revenue Service, your “tax home” is the general area where you are employed or conduct your business. Your tax home is not necessarily the place where you maintain a residence.
The IRS does not consider you to have a tax home in a foreign country if you are maintaining your “abode” in the United States, even if you are earning money from overseas. In this case, you will not be able to claim the Foreign Earned Income Exclusion. The IRS defines your “abode” as the place where you maintain your economic, family and personal ties. Keep in mind that simply maintaining a dwelling in the United States will not disqualify you from this tax benefit. Likewise, being in the United States temporarily or having a spouse or dependents living in your dwelling in the United States will not be an automatic disqualification either. Nevertheless, these factors will be considered.
Determining the location of your tax home will often be dependent on whether you are working in a foreign country temporarily or indefinitely. In general, your work assignment will be considered temporary if it is going to last for no longer than one year. However, if the assignment is expected to last for more than one year, the IRS will consider it indefinite.
If you determine that your work assignment does not qualify you to establish a tax home in a foreign country and you are unable to claim the Foreign Earned Income Exclusion, you may still be able to deduct some of your other expenses, such as lodging travel and meals.
Defining “Foreign Country”
The IRS defines a foreign country as a territory that is not under the sovereignty of the United States’ government. Thus, U.S. possessions like Guam and Puerto Rico will not qualify as foreign countries. However, other locations that are not controlled or owned by the U.S. are considered “foreign countries.”
Bona Fide Residence Test or Physical Presence Test
Perhaps one of the most complicated requirements facing expats who hope to claim the Foreign Earned Income Exclusion is the passing the bona fide residence test or physical presence test.
What Is the Bona Fide Residence Test?
The bona fide residence test requires you to become a bona fide resident of a foreign country for a period that includes an entire tax year. For the purposes of this test, “foreign country” is defined the same as it is with regard to the establishment of your tax home.
The IRS cautions taxpayers to remember that simply traveling to and living inside another country for a year will not automatically make them bona fide residents. However, if you are living and working in another country where you have established a residence and intend to remain for an extended or indefinite period, you are likely considered a bona fide resident.
Determinations of bona fide residence are made on a case-by-case basis. For this reason, it is important to consult an expat tax professional if you are hoping to qualify for the Foreign Earned Income Exclusion or any other tax benefit using this test.
Special Cases that Prevent Bona Fide Residence
- Statements Made to Foreign Authorities: In some cases, taxpayers can avoid paying income taxes in foreign countries by making a statement to the country indicating that they are not a resident and therefore not subject to taxation. However, if you make such a statement and the authorities in the country decide that you will not be considered a resident for income tax purposes, you will not pass the bona fide residence test. Likewise, if the authorities in the foreign country are still deliberating your case at the time of your tax filing, you won’t pass the bona fide residence test either.
- Treaties: Some income tax treaties made between the United States and other countries may prevent you from passing the bona fide residence test. However, this will not happen automatically. In order to determine whether a given tax treaty prevents you from passing the bona fide residence test, you will need to consult the provisions of the treaty carefully.
Can You Be a Bona Fide Resident for Part of the Year?
Once you are able to pass the bona fide residence test for a one or more entire tax years, the period for which you are considered a bona fide resident may extend into a portion of two additional tax years. Specifically, the IRS will consider you to have been a bona fide resident from the time you established the residence until the time you abandon it.
For example, if you established a bona fide residence in France on May 30, 2015 and you maintain your residence until July 31, 2017, the IRS will consider you a bona fide resident of France for all of 2016, as well as parts of 2015 and 2017.
Can You Leave the Country at All as a Bona Fide Resident?
You can still be considered a bona fide resident of a foreign country for the purposes of the Foreign Earned Income Exclusion even if you leave the country at times during the year. However, it must always be clear that you have an intention to return to the foreign country without unreasonable delay. The IRS will review the circumstances to determine if any trips you have taken during the tax year will prevent you from passing the bona fide residence test and claiming the Foreign Earned Income Exclusion.
What Happens during Reassignment?
If your employer reassigns you to another post before you have met the requirements of the bona fide residence test for a given tax year, it may or may not affect your ability to pass the test. In general, as long as you move directly from one post to the other outside the United States and you meet all other requirements, you have a good chance of passing the bona fide residence test. However, if you must return to the United States while waiting to be reassigned, it is likely that you will not be able to pass the bona fide residence test.
What Is the Physical Presence Test?
The physical presence test requires you to be physically present in one or more foreign countries for a minimum of 330 full days during a period of 12 consecutive months. Keep in mind that, although the 12-month period must be consecutive, the days themselves do not need to be consecutive. You can qualify for the Foreign Earned Income Exclusion using the physical presence test whether you are a U.S. resident alien or a U.S. citizen.
Many expats find that this test is easier to pass than the bona fide residence test because it only requires being present in a foreign country, as opposed to establishing a specific type of residence or demonstrating your intentions.
Defining “Full Day”
For the purposes of this test, the IRS defines a “full day” as a period of 24 consecutive hours that begins at midnight. During this entire period, you must be physically present in a foreign country and/or passing over a foreign country. You cannot count any days in which you were present in a foreign country in violation of U.S. law.
You can still meet this requirement even if you travel back and forth to the United States multiple times during the year. However, it is important to keep careful track of timing and plan accordingly to avoid spending too much time in the U.S.
Does it Matter Why I Was Abroad?
For the purposes of the physical presence test, your reason for being outside of the United States and present in a foreign country is not relevant. You can count any and all days you spent abroad, whether you were working, on vacation or traveling for some other purpose.
How Do I Count Time Spent Traveling?
Time spent traveling may or may not count toward your 330-day total. For example, when traveling to and from the United States, any time spent over international waters will not count toward your 330-day total. However, if you are traveling from one foreign country to another, your travel time can still be counted as long as it lasts less than 24 hours. If your trip takes more than 24 hours, you will lose all days spent traveling, and the next full day you can count will be the first full day spent at your destination.
When traveling from the United States, passing over a foreign country can affect which days are countable. In general, if you pass over a foreign country before midnight on the day you leave the United States, you will be able to count the day after you left as your first full day abroad for the purposes of this test.
What If Circumstances Out of My Control Prevent Me from Meeting Physical Presence Test Requirements?
Exceptions to the requirements of the physical presence test are not generally possible. If vacation, employer assignments, family emergencies or illness prevent you from being physically present in a foreign country for enough full days to meet the requirements of this test, you won’t pass the test and will not qualify for the Foreign Earned Income Exclusion unless you can pass the bona fide residence test instead. The only exceptions that may be made involve civil unrest, war and similar adverse conditions that make it impossible or unsafe to meet the time requirements of the physical presence test.
Make a Valid Election to Exclude Foreign Earned Income
Finally, in order to claim for Foreign Earned Income Exclusion, you must make a valid election. This means you must complete the appropriate sections of Form 2555 accurately and submit it with your tax return in order to claim this benefit.
Completing Form 2555
Form 2555 must be completed for each tax year you intend to claim the Foreign Earned Income Exclusion. You should complete this form and submit it to the IRS with Form 1040. Like Form 1040, Form 2555 is due on April 15 for most taxpayers.
To complete Part I of the form, you will need to list your address, as well as the location of your tax home or tax homes and the date of establishment. If you are planning to use the bona fide residence test to qualify for the Foreign Earned Income Exclusion, you will need to complete Part II of the form. If you are planning to use the physical presence test, on the other hand, you will need to complete Part III. Both of these parts of the form require you to provide details to show you meet the requirements of the specific test you have chosen.
For Part IV of Form 2555, you will list all of the foreign earned income you received during the tax year. In Part V, you will calculate the total of your foreign earned income and indicate whether you are claiming the housing exclusion or deduction. If you plan to claim a housing exclusion or deduction, you must complete Part VI. If not, you will skip to Part VII. The remainder of the form will guide you through the calculation of your Foreign Earned Income Exclusion for the year, as well as any housing exclusion you are able to claim.
What Type of Income is Covered by the Foreign Earned Income Exclusion?
The Foreign Earned Income Exclusion applies to income you earn while performing services, either as an independent contractor or as an employee. Examples of income that qualifies to be excluded using this tax advantage include professional fees, wages and salary payments. You can claim the Foreign Earned Income Exclusion even if you are self-employed. However, it is important to remember that this tax advantage cannot be used to reduce your self-employment tax liability.
What Is the Foreign Earned Income Exclusion for 2019?
Each year, the IRS updates the amount of income you can exclude from your taxable income using the Foreign Earned Income Exclusion. The IRS recently announced that the limit for 2019 will be set at $105,900. This means that taxpayers can use the Foreign Earned Income Exclusion to eliminate as much as $105,900 from their U.S. taxable income if they meet the necessary requirements.
For married taxpayers who are filing jointly, the maximum amount that can be excluded under the Foreign Earned Income Exclusion doubles. Any foreign income earned above this amount may be subject to taxes. However, you may be able to eliminate or reduce any taxes that result from the excess income using other tax advantages available, such as the Foreign Tax Credit.
What Is the Foreign Earned Income Exclusion for 2020?
At this time, the IRS has not yet released the exact limit that will apply to the Foreign Earned Income Exclusion in 2020. It is likely that the limit will be equal to or higher than the amount established for 2019.
Can You Claim the Foreign Earned Income Exclusion for Only Part of the Year?
If you qualify for the Foreign Earned Income Exclusion for only part of the tax year, you can still claim this tax benefit. However, you will need to modify the way you calculate the excluded tax amount accordingly.
First, you must determine the number of days in the year for which you qualify. Qualifying days are days in which you pass either the bona fide residence test or the physical presence test AND have your tax home in a foreign country. Once you have calculated this amount, you will need to adjust the limit to your Foreign Earned Income Exclusion based on the number of qualifying days in the year. Simply multiply the excludable amount of income based on the number of qualifying days divided by the total number of days in the year.
What Are the Most Common Problems Taxpayers Experience with the Foreign Earned Income Exclusion?
Determining whether you qualify for the Foreign Earned Income Exclusion, calculating the amount of the Foreign Earned Income Exclusion and actually claiming this tax benefit can be complicated. As a result, it is important for all taxpayers to be aware of the most common issues experienced and how to prevent them. Some of the most frequent mistakes made include:
- Failing to realize that you still owe self-employment tax: The Foreign Earned Income Exclusion cannot be used to eliminate self-employment tax liability to the United States, even if you meet all of the requirements for the Foreign Earned Income Exclusion and all of your money is earned overseas. You will still be responsible for paying these taxes. Failing to pay what you owe will result in penalties.
- Claiming the Foreign Earned Income Exclusion as a Government Employee: If you are an employee of the United States Government and you receive payment from the United States Government, you will not qualify to claim the Foreign Earned Income Exclusion even if you meet every requirement.
- Failing to calculate the Foreign Earned Income Exclusion properly: Calculating the Foreign Earned Income Exclusion can be challenging, especially if you are only able to claim this benefit for a portion of the tax year. It is important to be aware of what types of taxable income you can exclude under the Foreign Earned Income Exclusion, as well as the annual exclusion limit. You must also be sure to subtract the amount of your Foreign Housing Deduction.
- Claiming the wrong tax benefits:The Foreign Earned Income Exclusion is not the only tax benefit available to U.S. expats. For example, many expats also have the opportunity to claim the Foreign Tax Credit. However, the same income cannot be used for both tax benefits. For this reason, it is important to consider how each of these benefits would affect your tax bill and allocate income in the best way possible. While many taxpayers will find that the Foreign Earned Income Exclusion minimizes their United States tax liability, others will find that the Foreign Tax Credit saves them more money.
- Failing to consult a professional when necessary: Because the laws surrounding the Foreign Earned Income Exclusion are so complicated, many expats will need to work with a professional tax preparer to ensure that they are able to qualify for this tax benefit and that they are claiming it appropriately. Unfortunately, not all expats consult tax professionals, which may lead to inaccurate tax returns, overpaid or underpaid U.S. taxes, IRS penalties and other negative consequences.
Do I Need to Consult an Expat Tax Preparer?
Even if you understand the basics of the Foreign Earned Income Exclusion, it is still in your best interest to consult a professional expat tax preparer who has experience with this tax benefit and expat taxes in general. A professional expat tax preparer will be able to review your individual case, let you know whether you qualify to claim this benefit, complete all of the required paperwork and make sure that the exclusion has been calculated and elected properly. Some of the other benefits of hiring a professional expat tax preparer include:
- Access to in-depth knowledge about expat taxes – Professional tax preparers who specialize in expat taxes will be able to help with more than just the Foreign Earned Income Exclusion. They can help with every aspect of the preparation and filing process.
- Minimal tax liability – A competent tax preparer will be able to help you minimize your liability for United States taxes while still ensuring that you are in compliance with all relevant laws.
- Protection from penalties – Failing to meet the IRS requirements as an expat can lead to harsh consequences, including interest, monetary penalties and even legal charges. A professional expat tax preparer will help you avoid all of these negative consequences.
- Representation in an audit – Even if you do everything right, you can still be subjected to an IRS audit at any time. Complying with an audit is difficult for all taxpayers, but it can be even more overwhelming when you are an expat. Working with a tax preparer who specializes in expat taxes ensures that you will have the support and assistance you need if your tax return is selected for an audit.
- A chance to fix past problems – In some cases, expats are out of compliance with the IRS because they were unaware of requirements or otherwise neglected to file or pay taxes as they should have. An expat tax professional can help you resolve these matters with the IRS as quickly and cost-effectively as possible.
- Peace of mind – Trying to keep up with all of your tax obligations as an expat can be overwhelming. With the help of an expat tax professional, however, you can meet all of your requirements and rest easily knowing that you are in good standing with the IRS.