Many expats can exclude their US income from US Income Tax with the Foreign Earned Income Exclusion (or FEIE). Here is a simple breakdown of the rules.
Disclaimer: Please note that this guide is meant only as a general introduction. Every situation is different and this guide does not cover several key details that may be needed for filing your US taxes accurately. Be sure to get help from a professional tax preparer who specializes in expat tax returns.
Expat Taxes and the Foreign Earned Income Exclusion
US expatriates living abroad have a few options when it comes to minimizing or negating their US tax liability, one of them being the Foreign Earned Income Exclusion or FEIE.
The FEIE is designed to allow expats to elect to exclude about $100,000 of their earned wages from being subject to income tax. This amount increases slightly every year with inflation. To qualify for the Foreign Earned Income Exclusion, an Expat must qualify by passing the “Physical Presence Test” or the “Bona Fide Residence Test”.
Keep in mind that, for several reasons, it may make sense to claim the foreign tax credit instead of the foreign earned income exclusion. This might depend on many factors, however, so we strongly recommend that you seek help form an expat tax professional.
The Foreign Earned Income Exclusion and the Physical Presence Test
If an expat spends 330 days outside of the United Sates, he or she will likely qualify for the FEIE. In my opinion, this is the preferred way to claim the exclusion as it is so black and white and easy to prove is substantiation becomes necessary.
It is important to note that expats can use any twelve month rolling period to qualify for the exclusion, but they can only allocate the exclusion amount to the number of days that the twelve month period falls within the tax year.
The Foreign Earned Income Exclusion and the Bona Fide Residence Test
If an expatriate wishes to elect the exclusion, but spends too much time in the United States, there may still be hope to legitimately claim the exclusion. Expats who have living in the same location uninterrupted for a full tax year might qualify. Some taxpayers have taken this to mean that they can’t return to the United States at all from January 1st to December 31st in a year.
I don’t agree.
Most interpretations reason that this “living” requirement does not include vacations and short visits with the intention of returning overseas to live and work.
The problem with claiming the exclusion under this test, however, is that it is not so black and white. If the IRS examines this claim, they will consider other factors as the individuals living intentions, length of stay, intent to return to the United States, and other factors.
It always makes me a bit nervous to bet the income tax on $100,000 per year based on something that the IRS can take away if they so choose.
Still, if an expat qualifies, and he or she legitimately has every intention of creating a permanent residence in a specific place outside of the US, then they do have the option of claiming the foreign earned income exclusion under this test.
Tax Traps Related to the Foreign Earned Income Exclusion
The first thing most expats do not realize when they prepare the exclusion forms is that any non-excluded income is generally subject to the tax rate on the entire earnings. For example, if you earn $120,000, and you exclude $100,000, you face tax on the remaining $20,000 as if you were in the tax bracket for $120,000 earners (because you are). There is a worksheet for the calculation.
Excluded income generally does not qualify as income earned toward IRA contributions. In other words, if you make $50,000, and it is all excluded, then you can’t legally make a contribution. Many expats learn this after years of contributing to their IRAs. The trap here is that the penalties for this mistake are massive.
Revoking the Election
If you claim the foreign earned income exclusion in one year, and then do not claim it in the net year, then you probably cannot again elect the exclusion for five years unless you apply specifically for an exception. The IRS doesn’t give much guidance, but I’m assuming you must have a good reason. The IRS considers exceptions on a case by case basis. One acceptable reason that comes to mind might be if you had to leave the country because you or your family were living under unsafe conditions and had to flee while conditions stabilize. For information on filing for the exception, click here.
No Double Dipping with the Foreign Tax Credit
You mostly can’t take the foreign tax credit on income excluded under the foreign earned income exclusion. You can’t double dip.
In some cases you might choose one over the other.
In other cases it might be best to claim them both, though you must reduce your foreign tax credit by a ratio of your excluded income.
The Foreign Earned Income Exclusion will Only Exclude Income Tax
If you have income from a business or self employment, it may be subject to “self employment tax”. Self employment tax is the social security and medicare that is not taken out of wages. Expats might qualify for an exemption to these taxes by treaty, but the foreign earned income exclusion has no effect on this tax. Many US people living abroad with income from self employment will have to pay this tax, and the exclusion will not help them.
The Ability to Elect the Foreign Earned Income Exclusion Expires
You must elect the foreign earned income exclusion within one year after the end of the tax year.
So far, the IRS has been granting relief for this rule for expats who have not filed but have come forward to get caught up on their filing voluntarily.
Allegedly, when the IRS asks an expat to file delinquent returns, rather than the expat coming forward voluntarily, that they will not provide this amnesty. This seems to be the consensus among the expat professional community, but I have to official IRS reference to substantiate that point.
Must be Earned Income
They key is in the term “earned”. Investment income does not qualify. Rental income, collected from being a landlord, will likely only partially qualify. 401k and IRA account income also does not qualify. It pretty much has to be income from wages or from business/self employment.
We have experience with preparing and filing the foreign earned income exclusion for US Taxpayers. If you would like our help, please contact us at our Expat Tax Services page.