The IRS Foreign Earned Income Exclusion for US Expats – The Complete and Definitive Guide

The IRS Foreign Earned Income Exclusion for US Expats – The Complete and Definitive Guide

The United States has an unusual tax system compared to most other countries, in that it taxes all US citizens on their worldwide income, regardless of where in the world they live.

Most other countries either tax just residents, or only folks with income sourced in the country.

The US tax system though requires all American citizens, including expats, who meet minimum worldwide income thresholds of $12,000, or just $400 of self-employment income, to file US taxes. Unfortunately, the tax treaties that the US has with other countries don’t affect this requirement.

This in turn means that those millions of US expats who qualify to file foreign taxes in the country where they live too are at risk of paying income taxes twice.

To mitigate this risk, the IRS has made available a number of provisions that expats can utilize when the y file their federal US tax return. One of the most important and useful of these provisions is called the Foreign Earned Income Exclusion.

The Foreign Earned Income Exclusion doesn’t discriminate however between expats who are paying taxes abroad and those who aren’t, which is to say that expats who live in a no tax country or who don’t qualify to pay foreign taxes in any country can still claim the Foreign Earned Income Exclusion to reduce their US tax bill, often to zero.

In this article we’ll look at the Foreign Earned Income Exclusion in depth: what it is, what it isn’t, who qualifies for it, how to claim it, and in what circumstances expats benefit from claiming it.

What is the Foreign Earned Income Exclusion?

The Foreign Earned Income Exclusion is an IRS exemption that American expats can claim when they file their US tax return from abroad to reduce (or in many cases completely eliminate) their US tax bill.

It allows expats to exempt the first around $100,000 of their earned income from US taxation. The exact threshold rises a little each year for inflation, so for example in 2018 the threshold is $103,900, in 2017 it was $102,100, in 2016 $101,300, in 2015 $100,800, and so on, while for 2019 tax year (so for tax returns filed in 2020) it is due to be $105,900.

Married US expats can each exclude the Foreign Earned Income Exclusion amount, assuming that they both have earned income and meet the IRS tests for living abroad described below.

Expats should note that the Foreign Earned Income Exclusion can only be used to exclude certain types of income however (see below for details).

“If you are a U.S. citizen or a resident alien of the United States and you live abroad, you are taxed on your worldwide income. However, you may qualify to exclude from income up to an amount of your foreign earnings that is adjusted annually for inflation.” – the IRS

To claim the Foreign Earned Income Exclusion, expats must file form 2555 when they file their federal tax return. They must also meet IRS criteria for living abroad to qualify.

Some expats may be able to use a simplified, shorter version of form 2555 to claim the Foreign Earned Income Exclusion, form 2555-EZ. To qualify for using form 2555-EZ, expats must meet the following criteria:

1 – They are not also claiming the Foreign Housing Exclusion or Deduction

2 – The period they are claiming for is a calendar year

3 – They have no self-employment income

4 – They don’t earn more than the threshold for that year

5 – They have no business or moving expenses for that year

Qualifying for the Foreign Earned Income Exclusion

To claim the Foreign Earned Income Exclusion, expats must demonstrate that they live abroad by meeting one of two IRS definitions. It’s important for expats to clearly understand these definitions, as a small error can mean the difference between qualifying or not, and therefore whether they face a US tax bill or not.

The IRS has set out two tests for living broad, and expats need meet just one to be able to claim the Foreign Earned Income Exclusion. The first of these two tests is called the Physical Presence Test.

The Physical Presence Test requires expats to prove that they spent at least 330 complete days outside the US in a 365 day period that coincides with the tax year. Expats normally claim for the exact calendar year (i.e. the tax year), however expats who moved abroad mid year, or who moved back to the US mid-year, can claim just for the period when they lived abroad so long as they were abroad for at least 330 days after they moved abroad (assuming that they moved abroad mid-year, or before, if they moved back to the US mid-year).

The second of the two IRS tests is known as the Bona Fide Residence Test, and it requires expats to prove that they are a permanent resident in a foreign country. This might be by having a permanent residency visa, or by paying foreign income taxes based in their country of residence, or through proof of housing rental or ownership along with utility bills all in the expat’s name.

The Physical Presence Test is useful for expats who are moving between countries (such as Digital Nomads) or who can’t demonstrate permanent residence in any one foreign country. It does require expats to limit and count the days they spend in the US though, to ensure they spend at least 330 full 24 hours periods abroad. The Bona Fide Residence Test on the other hand is useful for expats who can demonstrate residence in another country and don’t want limits placed on the amount of days they spend in the US each year.

Types of income

The Foreign Earned Income Exclusion can only be used to exclude some income types, rather than any and all income, from US taxation.

Specifically, it can only be used to exclude earned income.

Earned income is defined as income arising as a result of work or services rendered. This includes salary income, wages, commissions, bonuses, self-employment income, and professional fees as well as the value of any other compensation for services, such as food and travel allowances, professional training, relocation expenses, etc.

It doesn’t matter where in the world payment is made or received, including the US, so long as the income qualifies and the expat can prove that they lived abroad when they earned it according to the IRS tests described above.

Unearned income can’t be excluded on the other hand. Examples of unearned income are social security benefits, pension income, rents, dividend income, interest, gambling winnings, capital gains, annuities, and alimony payments.

Further examples of income types that can’t be excluded by expats claiming the Foreign Earned Income Exclusion are:

– Payments received as a military or civilian employee of the U.S. Government

– Payments received for services conducted in international waters

– Payments received after the end of the tax year or other 365 days period being claimed for, even if the service was performed during that time

– Meals and lodging that are excluded from income for the convenience of the employer

You are probably beginning to appreciate that far from the Foreign Earned Income Exclusion being a total solution for all expats to avoid paying US taxes, it very much depends on their circumstances, including their income types and levels, and their foreign residency or travel arrangements.

The US Foreign Earned Income Exclusion for Expats
Expats earning in a foreign currency must convert it into USD when claiming the Foreign Earned Income Exclusion

Limitations of the Foreign Earned Income Exclusion

The Foreign Earned Income Exclusion is certainly not a golden ticket that prevents expats from having to file US taxes.

It has multiple limitations. Firstly, it doesn’t prevent expats from having to file a US tax return, declaring their worldwide income. (If they earn in a foreign currency, they must convert it to US dollars to report it son their US tax return). As already illustrated, expats still need to file a federal return and ensure that they qualify in terms of proving that they live abroad, and also in terms of whether their income qualifies as ‘earned income’ according to the IRS definition.

The threshold of around $100,000 dollars is also limiting for expats who earn over this amount, though other options may be available for them to avoid double taxation (such as the Foreign Housing Exclusion, and the Foreign Tax Credit, details about which are below).

Neither does successfully claiming the Foreign Earned Income Exclusion prevent self-employed expats from having to pay social security and medicare taxes, which can amount to 15.4% of an expats’s income (although there may be ways to avoid this, too, depending on each expat’s circumstances).

Finally, some expats may also have to continue filing state taxes from abroad, depending on the rules in the state where they last lived, even if they successfully claim the Foreign Earned Income Exclusion.

The Foreign Housing Exclusion/Deduction

Expats who claim the Foreign Earned Income Exclusion but who earn over the Foreign Earned Income Exclusion threshold of around $100,000 and who rent a home abroad can exclude further income by claiming the Foreign Housing Exclusion.

The Foreign Housing Exclusion lets expats who are employed abroad and who earn over the Foreign Earned Income Exclusion limit exclude a further amount of their income from US taxation based on a proportion of their housing expenses.

The formula for how much of their income above the Foreign Earned Income Exclusion threshold expats can exclude from US taxation is a bit complex, being their total housing expenses minus 16% of the Foreign Earned Income Exclusion amount, up to a maximum total of normally 30% of the Foreign Earned Income Exclusion threshold, although this maximum varies depending on which country and city the expat is living in, according to an IRS list which is updated annually, and can be found in form 2555 instructions.

“In addition to the foreign earned income exclusion, you can also claim an exclusion or a deduction from gross income for your housing amount if your tax home is in a foreign country and you qualify for the exclusions and deduction under either the bona fide residence test or the physical presence test.” – the IRS

Qualifying housing expenses include rent payments, utilities bills (other than telephone and TV), fees for securing a leasehold, residential parking costs, occupancy taxes, property insurance, furniture rental, and necessary repairs.

Mortgage payments, purchased furniture, and domestic help costs don’t qualify on the other hand.

Expats can claim the Foreign Housing Exclusion on the same form they use to claim the Foreign Earned Income Exclusion, IRS form 2555.

Self-employed expats who claim the Foreign Earned Income Exclusion and who rent their home abroad can’t claim the Foreign Housing Exclusion, but can instead claim the Foreign Housing Deduction, which functions in a similar way.

Both the Foreign Housing Exclusion and Deduction can be claimed on form 2555 along with the Foreign Earned Income Exclusion, but not on form 2555-EZ.

Form 2555 instructions

Form 2555 is not the most straightforward form to complete, and we recommend that expats with any queries or doubts seek assistance from a reputable and experienced expat tax preparation specialist to ensure that they don’t make any costly errors.

The form has 9 sections. Section I is for personal details, employer’s details (if applicable), and for establishing where an expat’s tax home is.

Section II is used by expats who meet the Bona Fide Residence Test, while Section III is for expats who meet the Physical Presence Test. Expats only need complete one of these two sections.

Section IV is for expats’ earned income and expenses details, which should correspond with the figures they enter in form 1040.

Sections V and VI relate to the Foreign Housing Exclusion/Deduction, while the final three sections (VII, VIII, and IX) are where expats enter the final figures used to calculate the total amount they will be excluding.

Who should claim the Foreign Earned Income Exclusion?

The Foreign Earned Income Exclusion is a completely legal way for many expats to reduce their US tax bill, often to zero, although they still have to continue filing a US tax return each year, reporting their worldwide income.

In particular, expats who earn less than the annual Foreign Earned Income Exclusion threshold, whose only income is earned, who either don’t pay foreign taxes or who pay foreign taxes at a lower tax rate than the US rate, and who can prove that they live abroad according to the IRS criteria often benefit from claiming the Foreign Earned Income Exclusion .

Many Digital Nomads fall into this category, as even if they aren’t required to pay taxes in any foreign country as they are travelling from country to country while working, so long as they are outside the US for at least 330 days a year and do not maintain a US abode, they can use the Foreign Earned Income Exclusion to reduce or eradicate their US tax bill.

In contrast though, expats with unearned income, those who earn over the annual Foreign Earned Income Exclusion threshold, those who pay foreign income taxes at a higher rate than the US rate, and those who are unable to fulfill IRS criteria to prove that they live abroad may need to explore other options to avoid paying US taxes from abroad.

Expats whose income is paid in a foreign country and who pay foreign income taxes for example may be better off claiming the US Foreign Tax Credit, which they can claim to offset their US tax bill based on the value of the foreign tax that they’ve already paid. If they pay foreign tax tat a higher rate than the US rate, this will not only eradicate their US tax liability but also give them excess US tax credits that they can carry forward for up to ten years (or back one year, if they file amended returns for those years). Other advantages of claiming the Foreign Tax Credit rather than the Foreign Earned Income Exclusion for expats are that there is no IRS limit set on the amount of tax credits that can be claimed, and that it doesn’t matter whether the income is earned or unearned, so long as foreign income tax has been paid on it.

Expats can claim the Foreign Tax Credit by filing form 1116 along with their federal return.

Expats who pay foreign taxes on income that is paid in the US can’t claim the US Foreign Tax Credit however, so if they can’t claim the Foreign Earned Income Exclusion either, perhaps because their US sourced income isn’t ‘earned’, or because they can’t prove that they live abroad, they may be able to claim tax credits against US taxes paid on their income in the country where they live.

Expats can claim both the Foreign Tax Credit and the Foreign Earned Income Exclusion, but not apply them to the same income. So for example a freelancer who receives income in the US and also abroad, and who pays a higher rate of foreign income tax on their worldwide income in the country where they live, could choose to claim US tax credits against the foreign taxes paid on their foreign sourced income, and the Foreign Earned Income Exclusion on their US sourced income, so eradicating their US tax bill.

FBARs and amnesty programs

Expats may also have to report their foreign bank and investment accounts, if they have over $10,000 in total in qualifying accounts at any time during a tax year, by filing a Foreign Bank Account Report, more commonly known as an FBAR.

Expats who are behind with their federal tax or FBAR filing because they weren’t aware of the requirement to file from abroad can catch up without facing penalties under an IRS amnesty program called the Streamlined Procedure. The program requires expats to file their last three tax returns, and up to their last six FBARs, if required. The program allows expats to claim the Foreign Earned Income Exclusion (and/or the Foreign Tax Credit) retrospectively.

We strongly recommend that expats who have any doubts or queries relating to their US tax filing obligations contact us at their earliest convenient to seek advice to ensure that they don’t fall foul of the IRS.

Register now, and your Bright!Tax CPA will be in touch right away to guide you through the next steps.

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