With all Americans, including expats, having to report their worldwide income by filing a US federal tax return every year, the Foreign Earned Income Exclusion provides Americans living abroad a way to reduce their US tax bill (in many cases to zero).
In 2021, for many Americans expats around the world filing their 2020 US tax returns, claiming the Foreign Earned Income Exclusion is the best way to avoid paying US tax.
To claim the Foreign Earned Income Exclusion, expats must first meet the qualification rules, and then file a timely federal US tax return, including IRS Form 2555.
Expats receive an automatic two-month filing extension, until June 15th, and can request further time too if needed, until October 15th, by filing Form 4868.
Qualifying for the Foreign Earned Income Exclusion in 2021
To claim the Foreign Earned Income Exclusion in 2021, Americans have to prove that they lived abroad in 2020 in one of two IRS tests.
The first test is called the Bona Fide Residence Test, and it involves proving that you are a permanent resident in another country. This may include proof of paying foreign taxes, a permanent residency visa in another country, or evidence of maintaining your main home abroad.
The second test is called the Physical Presence Test, and it involves proving that you spent at least 330 days outside the US in 2020 (or in a 365 day period that coincides with 2020, for those that moved abroad or returned to the US mid-year).
“Foreign-earned income means wages, salaries, professional fees, or other amounts paid to you for personal services rendered by you.” – the IRS
The Physical Presence Test rules are a bit different relating to the 2020 tax year due to the Coronavirus Pandemic – more about this later.
What types of income can expats exclude in 2021?
Expats can only use the Foreign Earned Income Exclusion to exclude earned income. This covers all salaries, wages, self-employment income, and any other income received for services provided, such as bonuses or tips.
Unearned income such as rental income, interest, gambling winnings, benefits, pension distributions, and income from investments can’t be excluded on the other hand.
How much income can expats exclude in 2021?
There is a limit to the amount of earned income that expats can exclude when they claim the Foreign Earned Income Exclusion. This limit is adjusted each year to take into account inflation. For the 2019 tax year, it was $105,900, while for the 2020 tax year (for filing in 2021) the limit is $107,600.
For the 2021 tax year (for filing in 2022), it will rise to $108,700.
How does the Coronavirus Pandemic affect claiming the Foreign Earned Income Exclusion in 2021?
The Coronavirus pandemic can affect claiming the Foreign Earned Income Exclusion in 2021 in two ways.
First, the IRS has announced that anyone who expected to be able to claim the Foreign Earned Income Exclusion through residing abroad, and indeed was residing abroad beforehand, but was prevented from being abroad due to the Coronavirus pandemic, can still claim it.
This covers many Americans who couldn’t return to their home abroad after visiting the US early this year.
Second, Americans who didn’t qualify to receive a stimulus check in 2020 because their income was too high may still receive one in 2021, depending on their final 2020 financial circumstances. This is because the stimulus checks were considered non-refundable tax credits for the 2020 tax year, however they were calculated based on previous years’ tax returns, so if an American’s income ended up lower in 2020 than in previous years, they may still qualify.
When filing from abroad, expats almost always benefit from seeking specialist advice. The Foreign Earned Income Exclusion isn’t necessarily the best way to reduce expats’ US tax bills – for many expats, claiming the Foreign Tax Credit by filing Form 1116 may be preferable. Overall, the best way to file can only be determined based on each individual’s personal financial circumstances.
Americans living abroad who haven’t been filing US taxes because they weren’t aware of the requirement can catch up without facing penalties (and still claim the Foreign Earned Income Exclusion) under an amnesty program called the Streamlined Procedure.