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 qualify to reduce your U.S. taxable income up to an amount of your foreign earnings that is adjusted annually for inflation. In addition, you can exclude or deduct certain foreign housing amounts. This is known as the foreign earned income exclusion.
If you meet certain requirements, you may qualify for the foreign earned income exclusion which can reduce or altogether eliminate your taxable earned income. The necessary steps to qualify for the exclusion are summarized below, however qualification is based on a thorough analysis and determination based on the facts of the individual taxpayer’s situation.
Foreign Earned Income Exclusion Requirements
In order to be eligible for the foreign earned 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
“Tax home” is an important concept to understand because in order to claim the foreign earned income exclusion, the foreign housing exclusion (for employees) or the foreign housing deduction (for self-employed individuals), an individual must have a tax home in a foreign country or countries.
Your tax home is the general area of your main place of business, employment, or post of duty, regardless of where you maintain your family home. Your tax home is the place where you are permanently or indefinitely engaged to work as an employee or self-employed individual.
You will not be considered to have a tax home in a foreign country for any period in which your “abode” was in the United States. Abode is a subjective term and is based on facts and circumstances. Generally, abode has been defined as an individual’s home, habitation, residence, domicile or place of dwelling.
If you expect your employment away from home in a single location to last, and it does last, for 1 year or less, it is temporary unless facts and circumstances indicate otherwise. If you are temporarily absent from your tax home in the U.S. on business, you may be able to deduct your away-from-home expenses (for travel, meals and lodging), but you would not qualify for the foreign earned income exclusion.
If you expect it to last for more than 1 year, it is indefinite. If your work assignment is for an indefinite period, your new place of employment becomes your tax home and you would not be able to deduct any of the related expenses that you have in the general area of this new work assignment.
If your new tax home is in a foreign country and you meet the other requirements, your earnings may qualify for the foreign earned income exclusion. A foreign country is any territory (including the air space and territorial waters) under the sovereignty of a government other than that of the U.S. It does not include Puerto Rico, American Samoa, Guam, the Commonwealth of the Northern Mariana Islands, The U.S. Virgin Islands or other U.S. possessions.
If your tax home is still in the U.S., then it’s not possible to claim any of the exclusions/eduction even if you were considered a bona fide foreign resident of another country for that country’s tax purposes.
Bona Fide Residence Test
You meet the bona fide residence test if you are U.S. citizen or resident (who is a citizen of a country with which the U.S. has a tax treaty with a non-discrimination clause) and a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year (generally January 1 through December 31). If you are a U.S. resident alien and a citizen of a foreign country without a tax treaty clause (explained above), you must use the physical presence test (described below).
Establishing bona fide residence is determined based on the facts and circumstances of each individual taxpayer’s case. Some of the more common factors used to evaluate include:
- The individuals’s intent
- Extent of the individual’s assimilation into the life and society of the foreign country
- Living Quarters (purchased residence, rented house or apartment, employer provided housing, hotel)
- Family members residing with taxpayer or in U.S.
- issuing a statement to a foreign country denying residency in that foreign country
- Paying taxes to foreign government
- Contractual terms and conditions of employment
- Visa type and duration
- Maintenance of U.S home
An individual is not considered a bona fide resident of a foreign country if:
- the individual submitted a statement to the authorities of that country claiming to be a non-resident of that country, and
- the individual’s income is not subject to tax in that country because he or she is a non-resident of that country.
An individual does not automatically acquire bona fide resident status simply by living in a foreign country or countries for a full tax year. Rather, bona fide resident status is determined on a case by case basis. Since no one factor will determine if an individual meets the bona fide residence test, it is based on a careful and professional evaluation of all factors and facts of the individual’s situation to determine whether an individual has qualified as a bona fide resident of a foreign country
Physical Presence Test
An individual meets the physical presence test if physically present in a foreign country or countries for 330 full 24-hour days in a period of 12 consecutive months. In essence, this limits a taxpayer to 35 days in the U.S. during any 365-day physical presence qualification period.
The optimal 12-month period that provides the greatest amount of foreign earned income exclusion is based on a proper evaluation of the first and/or last foreign day in the foreign country (as applicable).
Foreign Housing Exclusion
As an individual taxpayer, you may also be able to exclude housing expenses in excess of a base amount and subject to a limit. The base amount is equal to 16% of the maximum foreign earned income exclusion multiplied by the number of qualifying days within the tax year. The US tax code limits the housing expenses eligible for the housing exclusion to 30% of the maximum foreign earned income exclusion. The result of the limitation is then multiplied by the number of days in the qualifying period that fall within the tax year. Self-employed taxpayers can qualify for a housing deduction rather than a housing income exclusion for employer-provided amounts.
A common misconception is that the foreign earned income exclusion is automatic. It is not. An election to exclude foreign earned income must be made on the Form 2555 that is attached to the taxpayer’s individual tax return. The election to excluded foreign earned income and the election to exclude the cost of foreign housing are separate elections. A taxpayer can make one or both elections.
These elections must be made with:
- a timely filed return (including any extensions)
- a return amending a timely filed return during the claim period
- a late-filed return filed within one year from the original due date of the return (determined without regard to any extensions)
In addition, the elections may be made on a return filed after the periods described above, provided:
- no federal income tax is owed after taking the exclusion into account, or
- federal income tax is owed after taking the exclusion into account but the returns is filed electing the exclusion before the IRS discovers that the individual failed to make the election
For more information about the Foreign Earned Income Exclusion, please read more in the IRS instructions for the Form 2555.
Determining eligibility for the foreign earned income exclusion is based on proper analysis and the individual facts of the taxpayer. If you need help with filing a U.S. tax return as an overseas taxpayer, request a free quote today to get started with a tax professional experienced in maximizing your qualification for the foreign earned income exclusion and accurate and complete preparation of your Form 2555.