How US Expats Save Tax With The Foreign Earned Income Exclusion
Many expats working abroad are concerned that they still have 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.
Expats can exclude some or even all their foreign earned income from their US income taxes with the Foreign Earned Income Exclusion (FEIE) – if they qualify. However, claiming this exclusion is not always the best approach for Americans working abroad.
What is the Foreign Earned Income Exclusion?
The Foreign Earned Income Exclusion, or FEIE, is an important tax benefit available to US taxpayers living abroad. As always with tax benefits, expats must meet specific criteria to qualify, which we explain below.
Under the FEIE, expats can exclude up to $105,900 of earnings for the 2019 tax year. The maximum exclusion amount goes up to $107,600 per qualifying person for 2020.
This exclusion is not automatic. Expats must claim the FEIE on IRS Form 2555 (more about this form later) with their US tax return.
How to qualify for the Foreign Earned Income Exclusion
Living abroad or spending a lot of time traveling outside the US is not enough to qualify for the FEIE. In order to claim the Foreign Earned Income Exclusion,
- your tax home must be in a foreign country, and
- you must meet either the Physical Presence Test or the Bona Fide Residency Test.
Let’s break that down.
Tax Home for Foreign Earned Income Exclusion
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.
Be aware that the IRS does not treat US possessions like Guam and Puerto Rico as foreign countries. Therefore, you won’t be able to claim the FEIE when living there. There are special tax incentives for US territories such as NMI, USVI, and Puerto Rico.
Physical Presence Test
To meet the 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-month period to maximize the exclusion will be covered in another post.
Bona Fide Residence Test
The criteria of the bona fide residency 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.
Generally, 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 a 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 this is not required).
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.
What is Foreign Earned Income?
Not all types of income can be excluded from US income tax using the Foreign Earned Income Exclusion. Only “foreign earned” income qualifies.
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 performed the work while in a foreign country.
However, not all income you might receive while abroad is eligible for the FEIE.
Income not eligible for the Foreign Earned Income Exclusion
Certain income does not qualify for the FEIE.
Passive income, as opposed to earned income, does not qualify. It includes:
- Pension payments
- Investment income
- IRA distributions
- Rental income
- Social security benefits
Income not earned in foreign countries
You can only exclude income earned while 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.
Furthermore, when you work during a visit back to the US, you cannot exclude the income earned during those working days.
Pay from the military, government, and its agencies
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.
Income earned while working in restricted countries such as Cuba, North Korea, Iran, and others does not count for the FEIE. (Yes, we have even seen this.)
As previously mentioned, the FEIE also does not apply to income earned in territories such as Puerto Rico. Those territories, however, have their own set of unique and VERY beneficial tax incentives (that we help clients achieve).
To claim the FEIE you must file Form 2555
You might think that you don’t have to file a US 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 automatically. In fact, if you don’t file your tax returns and claim the FEIE, you may lose the right to use it.
If you didn’t file US taxes as expat because you didn’t know you had to, don’t panic. You can still file returns late under the Streamlined Program and claim the FEIE. Speak to an experienced accountant to avoid any costly mistakes. (You can schedule a consultation here.)
To claim the exclusion, you file Form 2555, Foreign Earned Income together with your tax return.
Foreign Earned Income Exclusion limits and calculation
As mentioned earlier, the IRS adjusts the maximum exclusion amount every year for inflation. The FEIE limits per qualifying taxpayer are:
- $103,900 for the 2018 tax year
- $105,900 for 2019
- $107,600 for 2020
Americans working abroad can exclude foreign earned income up to those limits if they qualify for the exclusion. However, the actual exclusion amount is prorated based on the time you spent abroad that tax year.
For example, if you went abroad Oct 1, 2019, you could qualify for the FEIE by the time you file your 2019 taxes in 2020 (request an extension until October 15 to file). You would be able to exclude the last three months of the year, which is about a quarter of the $105,900 FEIE limit for the 2019 tax year.
Furthermore, any number of days spent working in the US would be subject to taxation at the federal (and potentially local) level.
Therefore, it is important to select the 12-month period with the most days in foreign countries to get the highest exclusion.
Impact of COVID-19 on qualifying for the FEIE in 2020
Due to the coronavirus pandemic, many US expats may spend more time “home” in the United States this year than they had planned. This might impact their ability to qualify for the Foreign Earned Income Exclusion for 2020.
In general, the Form 2555 instructions include a waiver of time requirements under certain circumstances, which tax filers must apply for individually. However, the waiver generally is only available for countries and time periods listed by the IRS every year.
The IRS has released guidance on the time periods for specific countries for the Adverse Conditions Waiver due to COVID-19.
The FEIE does not shield expats from self-employment tax
Self-employed expats shouldn’t forget about self-employment tax. The Foreign Earned Income Exclusion only excludes 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 net earnings from self-employment up to 132,900 for the 2019 tax year and $137,700 for 2020.
Learn more here about self-employment tax for US citizens abroad. Also, if you have significant income from self-employment, incorporating a business may be more tax beneficial.
Foreign Housing Exclusion/Deduction
The Foreign Housing Exclusion or Deduction is an often-overlooked tax benefit for US expats, that goes hand in hand with the FEIE. It is also claimed on Form 2555.
This exclusion allows US taxpayers living abroad to exclude certain housing expenses that they incur in a foreign country. Especially for expats living in expensive locations, this exclusion or deduction can be substantial.
Foreign Earned Income Exclusion vs Foreign Tax Credit
While the Foreign Earned Income Exclusion is a great way to minimize US taxes, it is not the only option. 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 depends on the specific circumstances. Generally, expats living in high tax jurisdictions like Northern Europe benefit more from the Foreign Tax Credit, while US citizens living in low or no tax countries are usually better off with the Foreign Earned Income Exclusion. However, additional considerations also influence the best approach.
An experienced expat tax accountant can run both scenarios for you and advise on the best approach.
Common mistakes expats make with the Foreign Earned Income Exclusion
The US tax code is complicated. Even seasoned US-based tax accountants are often not familiar with expat-specific tax provisions such as the exclusion of foreign earned income. It’s easy to make a mistake.
We review their last 3 years of tax returns of every new client to make sure we know about any carryovers and other special tax situations. In those reviews we also often find mistakes. In some cases, we were able to get up to $30,000 tax refunds by amending old returns.
Typical mistakes we see include:
- Not pro-rating the exclusion properly
- Overlooking FEIE related exclusions and deductions, such as the Foreign Housing Exclusion/Deduction
- Claiming the Foreign Earned Income Exclusion when the Foreign Tax Credit would have been more beneficial
- Improperly calculating the Sec 965 transition tax
- Reporting around owning and getting paid from foreign corporations
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 US taxpayers living abroad to seek the help of a professional when preparing their US expat tax returns.