You may have heard that you don’t need to pay US tax on money you earn abroad – and it can be true, if you meet specific criteria. The Foreign Earned Income Exclusion (FEIE) makes it possible for expats to exclude some or all of their foreign earned income from their US income taxes.
The FEIE can help you save on US taxes
Many expats that work abroad are concerned about still having to pay tax in the US, even when they don’t live there anymore. The Foreign Earned Income Exclusion can alleviate this to a significant extent.
Under the FEIE, you can exclude up to $103,900 of earnings for the 2018 tax year. The IRS adjusts this amount every year; it was $102,100 for 2017. (The IRS changed the FEIE limit for 2018 to $103,900 from the previously published $104,100. This reduction is due to a change in inflation adjustment from the Tax Cuts and Jobs Act.)
However, you must meet certain requirements to be able to use the Foreign Earned Income Exclusion.
If you do qualify, note that the FEIE can only shield your income from income tax. The FEIE does not reduce self-employment tax. You will still have to pay the 15.3% self-employment tax on your net earnings from self-employment up to $128,400 for 2018. Read more here about self-employment tax.
How to qualify for the Foreign Earned Income Exclusion
The type of income and your status abroad are crucial when it comes to qualifying.
- You must have “foreign earned” income, and
- You must be in a foreign country.
Let’s look at each requirement in detail.
What qualifies as “foreign earned” income for FEIE
Not all types of income can be excluded from US tax using the Foreign Earned Income Exclusion.
Foreign earned income includes wages, salaries, and self-employment income you receive while working in a foreign country. This also includes earnings from US based businesses.
It doesn’t matter if you are paid into a US or foreign bank account. Furthermore, it doesn’t matter if your employer is foreign or US based, as long as you have performed the work while in a foreign country.
Income you cannot exclude under the FEIE
Pension payments, investment income, IRA distributions, rental income, or social security benefits are not considered earned income. Therefore you cannot exclude those.
Income not earned in foreign countries
Furthermore you can’t exclude income you make while not in a foreign country. Specifically, International waters are not considered foreign.
This means that if you are working on a cruise ship or other vessel in international waters, you maybe not be able to use the FEIE to lower your income tax. However, if you have established bona fide residency in another country, you may still be able to claim a portion of the FEIE.
Military and civilian employees of the US government or its agencies also generally cannot exclude their pay under the FEIE. However, international organizations such as NATO may have special agreements with the IRS.
You must be in a foreign country to claim FEIE
In order to claim the Foreign Earned Income Exclusion, your tax home must be in a foreign country and you must meet certain criteria for residing abroad. Let’s break that down.
The IRS defines “tax home” as your regular or principal place of business, employment, or post of duty, regardless of where you maintain your family residence. You may have more than one tax home per year.
In addition you must pass one of the following tests:
- Physical Presence Test
You must be physically present in a foreign country or countries for at least 330 full days during any period of consecutive 12 months. The 12 month period does not have to be the same as the tax year; rather it can be any 12 month period that allows you to qualify for 330 full days. This means that it can actually straddle tax years, as long as it starts or ends in the tax year you are claiming the FEIE and ends before you file your tax return.
The IRS has specific rules on what constitutes a full day in a foreign country. How to count days correctly and find the best 12 months period to maximize the exclusion will be covered in another post.
- Bona Fide Residence Test
The criteria of this test are far more subjective than those of the physical presence test, as there is no set limit on the number of days you can spend in the US. Read more here about the advantages of bone fide residency.
Generally speaking, you are a bona fide resident if you can call another country “home” for an entire calendar year. This means you have likely rented or purchased property and you are in your host country legally with some sort of non-tourist visa. You may also have established bank accounts, businesses, or have foreign bills to pay. If you have a family, you may have moved them to the foreign country as well (although not in all cases).
If you are a bona fide resident, you may keep your house or other interests in the US. However, should you be audited you must be able to prove to the IRS that you have shifted your life to your host country.
Note that if you declare yourself a non-resident in your host country to avoid taxes there, you cannot claim to be a bona fide resident of that country.
To claim the FEIE you must file a tax return
You might think that you don’t have to file a tax return if you don’t owe any tax. However, this is a misconception that can have severe consequences.
The FEIE is an exclusion that you must claim on your tax return. Without claiming it, the IRS does not give it to you automatically. In fact, if you don’t file your tax returns and claim the FEIE, you may lose the right to use it.
To claim the exclusion, you have to file Form 2555, Foreign Earned Income, together with your tax return.
FEIE is not the only way to save
While the Foreign Earned Income Exclusion is a great way to minimize US taxes, it is not the only way. If you pay tax in a foreign country, you can also use the Foreign Tax Credit to offset your US taxes. Which option is more beneficial for you depends on your specific circumstances. An experienced expat tax accountant can run both scenarios for you and advise on the best approach.
As always with US tax law, the laws that apply to the Foreign Earned Income Exclusion are nuanced. A post like this can give you a broad overview, but cannot substitute for professional advice on your specific situation. We always encourage expats to seek the help of a professional when preparing the US expat tax returns.
Photo by Darren Flinders