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Expat Tax Essentials
If you’re an American living abroad, the Foreign Earned Income Exclusion (FEIE) could save you thousands of dollars on your US taxes. In this guide, we’re going to look at some important questions about the FEIE, such as:
Armed with the answers to these questions, you’ll be well on your way to reducing your US tax bill. Let’s get started!
The Foreign Earned Income Exclusion is a tax benefit that allows you to exclude a certain amount of foreign-earned income (over $100,000 USD) from US taxation.
The FEIE is one of the ways that the IRS helps expats avoid double taxation on their foreign-sourced income. Because the IRS assumes that you will be taxed in your country of residence on your foreign-earned income, it allows you to exclude this income from US taxation using the FEIE.
Every year, the amount of the FEIE is adjusted for inflation. Sometimes, this can cause confusion since early projections of the new FEIE limit may underestimate or overestimate the allowed excludable amount.
The FEIE limit for 2022 is $112,000. Thanks to inflation, the 2023 FEIE limit will increase to $120,000. This is the largest increase we have seen in recent years.
There are two tests that can determine whether you qualify for the FEIE, the Physical Presence Test and the Bona Fide Residence Test. Let’s take a closer look at both.
The Physical Presence Test is one way Americans working overseas can qualify for the FEIE and save money on their US tax return.
To pass this test, all of the following must be true:
The alternative to qualifying with the Physical Presence Test is by using the Bona Fide Residence Test.
To use this test, all of the following must be true:
If you’re like many expats, you may still have a home in the US. What you do with this home and how you classify it can make a difference in the types of tax benefits you will get as an expat.
Generally speaking, the government classifies your tax home where you primarily live and work, regardless of real estate or foreign rental income.
Your abode is determined by where you manage your personal, family, and economic ties. Where your family is can certainly play a role in determining your abode, but if you show that you’ve established a residence in your host country by integrating into society, having a home, and setting up a bank account, among other factors—your abode could be your host country.
As far as your property back in the States, you could rent it out, let your family live in it, or even leave it vacant. You’ll want to keep accurate records of your home in your host country, also, since that can go a long way in helping prove you are integrated into the foreign society.
Before deciding which test you’ll use to qualify for the FEIE, it’s important to fully understand the difference between the Bona Fide Residence Test and the Physical Presence Test.
Often, your specific situation will determine which test is the best option for qualifying for the FEIE. For instance, if you are on a foreign assignment with a specified end date (but for at least 330 full days), you’ll likely need to use the physical presence test.
If you’re unsure which test you should use—or whether you qualify for either—consult an expat tax professional to better understand your options.
Once you’re confident you qualify, you’ll need to complete and attach Form 2555 as part of your federal tax return.
To complete Form 2555, you will need to know:
Each expat is required to complete their own Form 2555—even spouses. If you file as married filing jointly, each spouse will need to complete their own Form 2555. You’ll then attach both forms to your joint tax return.
The FEIE only allows you to exclude foreign-earned income from your US expat taxes. But what exactly is foreign-earned income? To understand this concept, we have to look at what the IRS considers to be “earned income” and “foreign income.”
Earned income is the opposite of passive income. Passive income means income that is not directly related to traditional work, such as income from interest, capital gains, or a retirement plan. Earned income, on the other hand, means any income you’ve earned by working, such as:
Only earned income can be excluded using the FEIE. Passive income does not qualify.
Generally, the IRS classifies income as foreign or domestic based on where it is earned. If you are living and working abroad, then your income is considered to be foreign-earned income, even if you are being paid by a US company.
The opposite is true as well. If you are working in the US, your earnings are considered to be US-earned income. This is true no matter who pays your salary, whether it is a US company or a foreign company.
In most cases, if the IRS considers your income to be both earned and foreign, it can be excluded using the FEIE.
The precise definition of foreign-earned income can be complicated and nuanced. Consult an expat tax professional to learn the details of your individual tax requirements.
According to the IRS, a frequent error made by those who want to use the FEIE is assuming that since the income is excludable from tax, the taxpayer is not required to report income under the limit.
In other words, some taxpayers believe the exclusion recuses them from filing requirements if their income is under the limit. Don’t make that mistake! You must still file annual federal tax returns, and in order to exclude this income, you must qualify and fill out the required Form 2555.
Pro Tip: If you are behind on your US tax filing obligations, don’t panic. You can use the Streamlined Filing Compliance Procedures to catch up on your taxes without facing any penalties. (But don’t wait too long! If the IRS contacts you about your tax delinquency first, you may lose the privilege of this amnesty program.)
Under the Physical Presence Test, you can qualify for the FEIE by being outside the US for 330 out of any 12-month period. This 12-month period does not need to be the same as the tax year. For instance, you could qualify for the FEIE by living outside the US from April to April (rather than the tax year, which is January to December).
However, if you move abroad midyear, you will not be able to claim the full FEIE amount, which is intended for the full tax year. You will only be able to claim the portion of the FEIE that corresponds with the amount of time you spent abroad.
To figure out what your maximum exclusion amount is, simply multiply the maximum excludable amount for the year by the number of your qualifying days in the year. Then, divide that number by the number of days in the year.
For example, if you moved abroad in April 2022, you would calculate your FEIE amount for the 2022 tax year as follows:
$112,000 (FEIE limit in 2022) x (274 days (number of qualifying days) ÷ 365 (total number of days in the year)) = $84,076
Another provision to help avoid double taxation is the Foreign Tax Credit. The Foreign Tax Credit lets Americans offset their US tax bill based on any taxes they’ve paid (or owe) to a foreign government.
It’s worth noting that the Foreign Tax Credit is a true credit, not a deduction. What’s the difference?
As mentioned above, the Foreign Tax Credit is a credit. This means that you can use it to reduce your final tax bill by whatever amount you can claim, dollar for dollar. If you owe $4,000 in US taxes but can claim a $1,500 Foreign Tax Credit, you’ll only have to pay $2,500 ($4,000 – $1,500 = $2,500).
The amount you can claim as a Foreign Tax Credit will depend on what you pay (or owe) to a foreign government. This often means that Americans living in countries with a higher income tax rate than the US—such as Japan—can erase their US tax debt entirely.
However, the Foreign Tax Credit only applies to certain types of income, and there are unique considerations related to each foreign country. There is also a cap on how much you can claim each year.
Most importantly, you cannot claim both the Foreign Tax Credit and the FEIE in the same year. You must choose one or the other.
If you qualify for the FEIE, you are also eligible for the Foreign Housing Exclusion.
The Foreign Housing Exclusion allows you to reduce your US taxable income by a portion of your qualifying housing expenses. Qualifying housing expenses typically include rent, utilities (except TV and internet), insurance, property taxes, and furniture rentals.
Like the FEIE, to qualify for the Foreign Housing Exclusion, you must pass either the Physical Presence Test or the Bona Fide Residence Test.
The specific amount of housing costs that you can exclude depends on the country and city in which you reside. Generally, if you live in a city with a higher cost of living, you can exclude a higher amount from your US expat taxes.
Use this Foreign Housing Exclusion calculator to determine the amount you’ll be able to exclude.
Once you choose to use the FEIE (and/or the Foreign Housing Exclusion), you must use it every year you have foreign earned income—unless you formally revoke it.
Once revoked, you cannot use the FEIE for another five years without requesting permission from the IRS in a Private Letter Ruling at a cost of $2,000. The IRS does not always grant permission, either.
There are times when expats benefit from revoking the FEIE. Often, expats do this so that they can use the Foreign Tax Credit to offset their US taxes instead of the FEIE. In these cases, the individual has typically moved permanently to a country with a higher tax rate than the US and earns more than the amount they can exclude with the FEIE. Review this example to determine if the Foreign Earned Income Exclusion is the best way for you to save.
You should work with your tax professional to determine if electing or revoking the FEIE is right for you, as the calculations can be confusing.
The Foreign Earned Income Exclusion is a great tool for US expats to reduce their tax liability. However, it’s always a good idea to discuss your options with an expat tax professional to identify the best ways to save.
At Greenback Expat Tax Services, we help Americans around the world manage their US tax obligations. Just contact us, and our team of CPAs and IRS Enrolled Agents will uncover all the tax credits that apply to you.
In fact, we can even prepare and file your US expat tax return on your behalf. From start to finish, we’re ready to take the hassle out of your taxes!
Use our simple excel calculator to get an estimate of how the foreign earned income exclusion will save you money. It will make your day!