The Bona Fide Residence Test allows Americans living abroad to claim the Foreign Earned Income Exclusion, as well as the Foreign Housing Exclusion or Deduction.
Americans living abroad are still liable to file and pay US taxes, and the Foreign Earned Income Exclusion provides a way for Americans to exclude income earned while living abroad from US tax liability, and so avoid double taxation.
The Foreign Earned Income Exclusion allows Americans living abroad to exclude around $100,000 (the exact amount rises a little every year) of their income from US tax liability.
It is the primary way for Americans living abroad to avoid paying taxes to both the government of the country where they live and to the IRS on the same income, as the US taxes all of its citizens on their worldwide income, wherever in the world they live.
The Foreign Earned Income Exclusion must be actively claimed however, by filing form 2555 along with form 1040. It isn’t applied automatically.
Americans earning more than around $100,000 can also claim the Foreign Housing Exclusion (or the Foreign Housing Deduction if they’re self-employed) if they rent their accommodation abroad. These exclusions allow expats to exclude the same value as a proportion of their housing expenses from US tax liability.
Expats who earn over around $100,000 but don’t rent their accommodation abroad should consider claiming the Foreign Tax Credit, which gives a $1 US tax credit for every dollar of tax paid to a foreign government.
To claim the Foreign Earned Income Exclusion however, you must prove that you live abroad.
“There is no bright line test for bona fide residency. Whether you meet the test is determined on a case-by-case basis, taking into account your intention to remain or the purpose of your trip and the nature and length of your stay abroad.”
- Kelly Phillips Erb, Forbes
The Bona Fide Residence Test allows expats to prove that they live abroad, and so be able to claim the Foreign Earned Income Exclusion.
The onus is on the taxpayer to prove that they are a permanent resident in a foreign country for the entire tax year in question.
Unfortunately there is no clearly defined way of doing this, and the IRS judges each tax payer’s case on its own merits.
If are a permanent resident in the country where you live, and can prove it by providing utility bills, this will go a long way to proving Bona Fide residence there. Proof of paying foreign taxes in the country where you live is another way, as is showing proof of permanent employment or legal residence there, for example by providing an employment contract or a residence visa.
Being a permanent residence doesn’t mean that you can never travel to the US, though spending excessive time in the US during the tax year in question may undermine your case.
Neither does being a permanent resident mean that you never intend to return to live in the US; it just means that for the relevant tax year, your home and base was in a foreign country.
If you are living abroad but are not a permanent resident in a foreign country (perhaps you are roaming from country to country outside the US as a Digital Nomad), you can still claim the Foreign Earned Income Exclusion if you can prove that you spent more than 330 days in the tax year outside the US. This is known as the Physical Presence Test. If you spent 330 days outside the US in a 365 day period that overlaps with tax year, you can also claim the Foreign Earned Income Exclusion for the days in this period within the tax year.
For US expats who haven’t been filing a US tax return because they weren’t aware that they had to, there is an IRS amnesty program called the Streamlined Procedure that lets them catch up with their filing without facing any IRS fines or penalties.
With clients in over 150 countries, Bright!Tax is a leading US expat tax services provider for the 9 million Americans living abroad. If you have any questions regarding your tax situation, don't hesitate to get in touch for some advice.