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As a US citizen or green card holder living abroad, navigating the complexities of American tax rules can be daunting. Unlike many other countries that tax only income earned within their borders or require only residents to file, the US taxes its citizens and green card holders on their global income—no matter where they live.
This means that as a US expat, you may need to file two tax returns: one in your country of residence and one with the IRS. Fortunately, the US tax code offers tools to help avoid double taxation, namely the Foreign Earned Income Exclusion (FEIE) and the Foreign Tax Credit (FTC).
In this guide, we’ll break down the differences between the FEIE and FTC, who qualifies for each, and how to decide which is the right option for your situation. We’ll also address how to file for past years if you’re behind on your US tax filings.
What Is the Foreign Earned Income Exclusion (FEIE)?
The Foreign Earned Income Exclusion (FEIE) allows US expats to exclude a certain amount of their earned income from US taxation because they have spent a year or more abroad. This exclusion is updated annually to account for inflation. For the 2024 tax year, expats can exclude up to $126,500 of earned income.
To claim the FEIE, you’ll need to file Form 2555 as part of your federal tax return. Expats earning over the exclusion threshold may also qualify for the Foreign Housing Exclusion, which allows you to deduct housing expenses, like rent, in addition to the base exclusion.
Key Features of the FEIE
- Applies to Earned Income Only
The FEIE applies exclusively to earned income, such as wages, salaries, or self-employment income. It cannot be used to exclude passive income like dividends, rental income, or pensions. - Residency or Physical Presence Requirement
To qualify for the FEIE, you must pass one of two tests:- The Bona Fide Residence Test: Demonstrate that you are a legal resident of a foreign country or countries for an uninterrupted period that includes an entire tax year..
- The Physical Presence Test: Prove that you were physically present in a foreign country for at least 330 full days during a 365-day period overlapping with the tax year.
- Global Applicability
You can use the FEIE to exclude earned income regardless of where it was earned, as long as you meet either the bona fide residence or physical presence requirement.
Example: If you’re a freelance web designer living in France and earn $100,000, you can exclude the entire amount under the FEIE, assuming you meet one of the tests.
What Is the Foreign Tax Credit (FTC)?
The Foreign Tax Credit (FTC) allows US expats to claim a dollar-for-dollar tax credit on US taxes for income taxes they’ve already paid to another country. This is particularly beneficial for expats living in countries with higher income tax rates than the US.
To claim the FTC, you’ll need to file Form 1116 alongside your federal tax return.
Key Features of the FTC
- Applies to Active and Passive Income
Unlike the FEIE, the FTC can be applied to both earned and passive income, including rental income, dividends, and capital gains. - No Residency Requirement
You don’t need to meet any residency or physical presence tests to claim the FTC. The only requirement is that you’ve paid foreign income taxes. - US-Sourced Income Is Excluded
The FTC cannot be applied to US-sourced income, even if it’s taxed abroad. - Excess Credits Can Be Carried Over
If the foreign taxes you’ve paid exceed your US tax liability for the year, you can carry unused credits forward for up to 10 years or back to the previous year.
Example: You live in Germany and earn $80,000 from a local employer. If Germany’s tax rate exceeds your US tax rate, you may be able to eliminate your US tax liability entirely by claiming the FTC.
FEIE vs. FTC: Which Should Expats Choose?
Deciding between the FEIE and FTC depends on several factors, including your income type, tax liability in your host country, and residency status. Here’s a breakdown of key considerations:
Foreign Tax Liability
If you don’t pay income taxes in your country of residence (e.g., you live in a tax-free country like the UAE), you won’t qualify for the FTC. In this case, the FEIE may be your only option.
Residency Status
To claim the FEIE, you’ll need to prove either a year of residency abroad or spend no more than 35 days in the US during the tax year. The FTC has no such requirement.
Income Type
The FEIE is ideal for earned income, while the FTC can be applied to both earned and passive income (e.g., rental income or investments).
Tax Rates in Your Host Country
If the foreign tax rate is higher than the US rate, the FTC is often the better choice, as it allows you to eliminate US tax liability and carry forward excess credits.
Additional Considerations
- Additional Child Tax Credit: If you have children with US Social Security numbers, you may qualify for the refundable Additional Child Tax Credit of $2,000 per child. However, this credit is only available if you claim the FTC—not the FEIE.
- Mixed Income: If you have both earned and passive income, you may be able to use the FEIE for your earned income and the FTC to offset the taxes on your passive income.
Example Scenario:
John, a US expat living in Germany, earns $100,000 as a software developer and also receives $20,000 in rental income from a property he owns in France. John pays taxes in Germany on his salary and also pays French taxes on his rental income.
John can use the Foreign Earned Income Exclusion (FEIE) on Form 2555 to exclude his entire $100,000 salary from US taxes. For the $20,000 in rental income, which is not eligible for the FEIE, John can use Form 1116 to claim the Foreign Tax Credit (FTC). This credit will offset US taxes on his passive rental income by applying the taxes he paid in France.
Can Expats Claim Both the FEIE and FTC?
Yes, it’s possible to claim both, but not on the same income. For example, you could claim the FEIE to exclude earned income and the FTC to offset US taxes on passive income. This approach works well for expats with diverse income streams.
Filing Past Years: The Streamlined Procedure
If you’ve fallen behind on your US tax filing obligations, you’re not alone. Many expats are unaware that they need to file US taxes while living abroad. Fortunately, the IRS offers a penalty-free option called the Streamlined Filing Compliance Procedures. This program allows expats to catch up on up to three years of tax returns and six years of FBARs (Foreign Bank Account Reports) without penalties, as long as they file before the IRS contacts them.
In addition to catching up on filings, you can also retroactively apply the Foreign Earned Income Exclusion (FEIE) using Form 2555 and the Foreign Tax Credit (FTC) using Form 1116 if they apply to your situation. This could potentially reduce or eliminate US tax liabilities for those years. To qualify for the Streamlined Procedure, you must certify that your failure to file was non-willful. Working with an expat tax professional is highly recommended to ensure accuracy and compliance.
Navigating US Taxes With Confidence
For US expats, choosing between the FEIE and FTC is a critical decision that can significantly impact your tax liability. Both options offer unique benefits, and the right choice depends on your individual circumstances, including your income type, residency status, and host country’s tax rules.
Filing taxes from abroad is complex, but you don’t have to navigate it alone. At Bright!Tax, we specialize in helping expats manage their US tax obligations while maximizing their savings. Our team of expert CPAs can help you determine the best strategy for your situation, file your returns accurately, and bring you into full compliance with IRS regulations.
Schedule your free 20-minute consultation today and take the stress out of filing your US taxes from abroad.
Resources
1. IRS Foreign Income Exclusion Form
2. IRS Foreign Tax Credit Form
