The Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion is essentially a tool for workers that are living abroad. The exclusion is reported on Form 2555, which can be included with Form 1040.
As a US expat, 100% of your income is subject to the same tax rates that workers inside the US would be subject to. That said, you can use things like the Foreign Earned Income Exclusion and the Foreign Tax Credit to reduce your US expat taxes.
The Foreign Earned Income Exclusion allows you to exclude up to $105,900 of your foreign earned income on your 2019 expatriate tax return, $107,600 on your 2020 return. Since you will likely be paying for costs like housing and living expenses while earning income abroad, you may also be able to deduct some of these costs. This credit can offset some or even all of your US expat tax liability if you meet a few basic requirements.
The Residence Test
In order for US expats to qualify for the Foreign Earned Income Exclusion, they are required to meet one of two criteria:
- Work full-time inside a foreign country for an entire calendar year — known as the Bona Fide Residence Test
- Work inside a foreign country for at least 330 of any 365-day period — know as the Physical Presence Test
While each of these statements may appear to be similar, they are actually quite different. They are different due to the terms of how they would apply to your US expat taxes. US expats become eligible for the exclusion if they have worked overseas throughout an entire calendar year (January 1st-December 31st). They are then considered a bona fide resident. The second clause can be a bit more confusing when applying it to your Expatriate tax return.
The second clause essentially means that a person left the United States for business and has not returned for more than 35 days throughout the past 12 months. This clause in not based on a calendar year; it simply refers to any 12-month period (like April to April or September to September). Also note that it makes no reference to consecutive days. An expat would be considered ineligible if he made several 2-7 day trips back to the US that totaled more than 35 days during the 12-month period in question. The key to meeting the Physical Presence Test is to have spent 330 days physically present in a foreign country.
If a person meets either of the above conditions, then they are allowed to exclude up to $105,900 of your foreign earned income on your 2019 expatriate tax return, and $107,600 on your 2020 return. If you are married filing jointly, you would be able to deduct up to $211,800 for your and your spouses earned income from your US expat taxes for the 2019 tax year ($215,200 for the 2020 tax year). This amount is also indexed for inflation and increases each year. Additionally, you would qualify for the foreign housing deduction.
As the name implies, the Foreign Earned Income Exclusion relies solely on foreign earned income. Foreign income from sources such as dividends, interest and rental income are not included since this income is not “earned” in the IRS’s view. Additionally, US based income from things such as pensions will not qualify for this exclusion because it was not earned inside a foreign country.
Per usual with the IRS, there are some catches with the Foreign Earned Income Exclusion. For example, business owners may be forced to pay Self-Employment tax to the US. This would be a cash expense and would come out before the Foreign Earned Income Exclusion is applied. You may still be able to exclude your earnings after you have paid the self employment tax. For more complex situations a good place to start understanding your specific circumstance may be to consult an expat tax expert about your specific situation.
Another common scenario for the self-employed is when US expats move to countries where there is a Social Security treaty in place with the United States, like the UK. The US / UK treaty allows you to opt out of Social Security and enroll in the UK National Insurance Plan. By opting out of US Social Security, you could save about 15.5% annually on your US taxes!
Expats can also be taxed inside the United States in some situations even if they are a resident of a foreign country and worked well under 35 days inside the US. For example, let’s say that you fly to New York for two weeks to visit some friends. You have an employer who allows you to work outside the office and you decide to work a few days from your hotel room in NY. When it comes time to file your US taxes at the end of the year, you would be responsible for paying US taxes for the income you earned working inside the US. This is the case even if your employer is in a foreign country and you only spent 14 days total inside the United States the entire year. This would, in all likelihood, then need to be offset on your local country taxes.
The last thing to remember is that not all US expats are able to take advantage of the Foreign Earned Income Exclusion. If you are a US government employee and are paid by the US government, you will not be able to use the Foreign Earned Income Exclusion to minimize your US expat taxes. This includes individuals in the Armed Forces Exchange, commissioned and non-commissioned officers’ messes, Armed Forces motion pictures services and employees of kindergartens on Armed Forces installations.
More on the Foreign Earned Income Exclusion
Originally published on March 31, 2011. Updated on March 2020.