The Foreign Earned Income Exclusion is the largest tax advantage available to you as an expat. If elected, your first $91,500 earned overseas are exempt from income tax, unless you are an employee of the US government. Note that if you are a Foreign Service employee, and your spouse works in the local economy, the exemption still applies for your spouse. The following page is divided in two sections - a brief Executive Summary and Detailed Explanation of the Foreign Earned Income Exclusion.
The Residence Test
In order to benefit from the Foreign Earned Income Exclusion, the taxpayer must meet one of the following two criteria:
1) Work full time inside a foreign country for an entire calendar year- known as the Bona Fide Residence Test
2) Work outside of the United States for at least 330 of any 365 day period - known as the Physical Presence Test
While the two criteria may appear to be similar, they are actually quite different in terms of how they apply to your US expat taxes. US Expats automatically become eligible for the exclusion if they have worked overseas throughout an entire calendar year (January 1st-December 31st). They are then considered a bona fide resident. The second clause can be more confusing when applying to Expatriate tax return.
The second clause essentially means that a person left the United States for business and has not returned for more than 35 days throughout the past twelve months. This clause in not based on a calendar year; it simply refers to any twelve month period (ie April to April or September to September). Also note that it makes no reference to consecutive days; so a US Expat would be considered ineligible if he made several 2-7 day trips back to the US that totaled more than 35 days during the twelve month period in question. The key to meeting the "physical presence test" is to have spent less than 35 days in the US during a 12 month period.
If a person meets either of the above conditions they are allowed to deduct up to $91,500 of their foreign earned income from their US expat taxes. If you are married filing jointly, you would be able to deduct up to $183,000 from your US expat taxes for the 2010 tax year. This amount is also indexed for inflation and increases each year. Additionally, you would qualify for the Foreign Housing Deduction as well.
As the name implies, the Foreign Earned Income Exclusion relies solely on foreign income for calculation purposes and the income must be earned. Foreign income from sources such as dividends, interest and rental income are not included since this income is not "earned" in the IRS's view. Additionally, US based income from things such as pensions will not qualify for this exclusion because it was not earned inside a foreign country.
There are some catches and loopholes to the Foreign Earned Income Exclusion, so it is almost always advisable to consult a US Expat tax expert about your specific situation. For example, business owners may be forced to pay the Self-Employment tax inside the US and this is not considered part of the Foreign Earned Income Exclusion. However you may still be able to exclude your earnings after you have paid the self employment tax. Another common scenario for the self employed is when US Expats move to countries where there is a Social Security treaty in place with the United States, like the UK. The US / UK treaty allows you to opt out of Social Security and enroll in the UK National Insurance Plan. By opting out of US social security, you could save about 15% annually on your US expat taxes!
The last thing worth mentioning is that not all US expats are able to take advantage of the foreign earned income exclusion. If you are a US Government Employee and are paid by the US government then you will not be able to use the Foreign Earned Income Exclusion to minimize your US expat taxes. This includes individuals in the Armed Forces Exchange, Commissioned and non-commissioned Officers' messes, Armed Forces motion pictures services and employees of kindergartens on Armed Forces installations.
Other considerations and opportunities that American expatriates should be aware of include the following:
- Need to File State Returns: Certain taxpayers must maintain a state of domicile in the United States, and there will be tax obligations to that state (Varies by state, please contact us for details).
- Foreign Housing Exclusion or Deduction: 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, you have self employment income, and you qualify under either the bona fide residence test or the physical presence test.
- Retirement: You still qualify for the tax advantages of making contributions to a retirement account, such as SEP, IRA or ROTH IRA. These contributions are subject to certain limits based on your gross income, so for the most part the foreign earned income exclusion will not affect them.
- Other Income: Did you rent your property while living abroad? Your rental income is reported, along with related expenses including but not limited to mortgage interest expense. Dividend or other investment income? Reported, less related expenses.
- Are you self employed but working overseas? You are in need of a tax plan. You could be saving at least 6% of your gross income.
Following are excerpts from IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. Click here to download the complete publication [1.5 MB]. Below we present the key elements of qualifying for the Foreign Earned Income Exclusion, but you should consult the full publication for a complete explanation.
Who Qualifies for the Exclusions and the Deduction?If you meet certain requirements, you may qualify for the foreign earned income and foreign housing exclusions and the foreign housing deduction.
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 $91,500 (for 2010) of your foreign earnings. In addition, you can exclude or deduct certain foreign housing amounts.
RequirementsTo claim the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, you must meet all three of the following requirements.
- Your tax home must be in a foreign country.
- You must have foreign earned income.
- You must be either:
- A U.S. citizen who is a bona fide resident of a foreign country of countries for an uninterrupted period that includes an entire tax year,
- A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, or
- A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.
Tax Home in Foreign CountryTo qualify for the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, your tax home must be in a foreign country throughout your period of bona fide residence or physical presence abroad.
Your tax home is Tothe general area of your main place of business, employment, or post of duty, regardless of where you maintain your family home. Your tax home is the place where you are permanently or indefinitely engaged to work as an employee of self-employed individual. Having a "tax home" in a given location does not necessarily mean that the given location in your residence or domicile for tax purposes.
Temporary or Indefinite Assignment
The location of your tax home often depends on whether your assignment is temporary or indefinite. If you are temporarily absent from your tax home in the United States on business, you may be able to deduct your away-from-home expenses (for travel, meals, and lodging), but you would not qualify for the foreign earned income exclusion. If your new work assignment is for an indefinite period, your your new place of employment becomes your tax home and you would not be able to deduct any of the related expenses that you have in the general area of this new work assignment. If your new tax home is in a foreign country and you meet the other requirements, you earnings may qualify for the foreign earned income exclusion.
- If you expect your employment away from home in a single location to last, and it does last, for 1 year or less, it is temporary unless facts and circumstances indicate otherwise.
- If you expect it to last for more than 1 year, it is indefinite.
- If you expect it to last for 1 year or less, but at some later date you expect it to last longer than 1 year, it is temporary (in the absence of facts and circumstances indicating otherwise) until your expectation changes. Once your expectation changes, it is indefinite.
Bona Fide Residence TestYou meet the bona fide residence test if you are a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year. You can use the bona fide residence test to qualify for the exclusions and the deduction only if you are either:
- A U.S. citizen, or
- A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect.
Bona fide residence. To meet the bona fide residence test, you must have established a bona fide residence in a foreign country.
Your bona fide residence is not necessarily the same as your domicile. Your domicile is your permanent home, the place to which you always return or intend to return.
Example. You could have your domicile in Cleveland, Ohio and a bona fide residence in Edinburgh, Scotland, if you intend to return eventually to Cleveland.
The fact that you go to Scotland does not automatically make Scotland your bona fide residence. If you go there as a tourist, or on a short business trip, and return to the United States, you have not established bona fide residence in Scotland. But if you go to Scotland to work for an indefinite or extended period and you set up permanent quarters there for yourself and your family, you probably have established a bona fide residence in a foreign country, even though you intend to return eventually to the United States.
You are clearly not a resident of Scotland in the first instance. However, in the second, you are a resident because your stay in Scotland appears to be permanent. If your residency is not as clearly defined as either of these illustrations, it may be more difficult to decide whether you have established a bona fide residence.
Determination. Questions of bona fide residence are determined according to each individual case, taking into account factors such as your intention, the purpose of your trip, and the nature and length of your stay abroad.
Statement to foreign authorities. You are not considered a bona fide resident of a foreign country if you make a statement to the authorities of that country that you are not a resident of that country, and the authorities:
- Hold that you are not subject to their income tax laws as a resident, or
- Have not made a final decision on your status.
Uninterrupted period including entire tax year. To meet the bona fide residence test, you must reside in a foreign country or countries for an uninterrupted period that includes an entire tax year. An entire tax year is from January 1 through December 31 for taxpayers who file their income tax returns on a calendar year basis.
During the period of bona fide residence in a foreign country, you can leave the country for brief or temporary trips back to the United States or elsewhere for vacation or business. To keep you status as a bona fide resident of a foreign country, you must have a clear intention of returning from such trips, without unreasonable delay, to your foreign residence or to a new bona fide residence in another foreign country.
Example 1. You arrived with your family in Lisbon, Portugal, on November 1, 2006. Your assignment is indefinite, and you intend to live there with your family until your company sends you to a new post. You immediately established residence there. You spent April of 2007 at a business conference in the United States. Your family stayed in Lisbon. Immediately following the conference, you returned to Lisbon and continued living there. On January 1, 2008, you completed an uninterrupted period of residence for a full tax year (2007), and you meet the bona fide residence test.
Example 2. Assume the same facts as in Example 1, except that you transferred back to the United States on December 13, 2007. You would not meet the bona fide residence test because your bona fide residence in the foreign country, although it lasted more than a year, did not include a full tax year. You may, however, qualify for the foreign earned income exclusion or the housing exclusion or deduction under the physical presence test (discussed later).
Bona fide resident for part of a year. Once you have established bona fide residence in a foreign country for an uninterrupted period that includes an entire tax year, you are a bona fide resident of that country for the period starting with the date you actually began the residence and ending with the date you abandon the foreign residence. Your period of bona fide residence can include an entire tax year plus parts of 2 other tax years.
Example. You were a bona fide resident of Singapore from March 1, 2006, through September 14, 2008. On September 15, 2008, you returned to the United States. Since you were a bona fide resident of a foreign country for all of 2007, you were also a bona fide resident of a foreign country from March 1, 2006, through the end of 2006 and from January 1, 2008 through September 14, 2008.
Reassignment. If you are assigned from one foreign post to another, you may or may not have a break in foreign residence between your assignments, depending on the circumstances.
Example 1. You were a resident of Pakistan from October 1, 2007, through November 30, 2008. On December 1, 2008, you and your family returned to the United States to wait for an assignment to another foreign country. Your household goods also were returned to the United States.
Your foreign residence ended on November 30, 2008, and did not begin again until after you were assigned to another foreign country and physically entered that country. Since you were not a bona fide resident of a foreign country for the entire tax year of 2007 or 2008, you do not meet the bona fide residence test in either year. You may, however, qualify for the foreign earned income exclusion or the housing exclusion or deduction under the physical presence test, discussed later.
Example 2. Assume the same facts as in Example 1, except that upon completion of your assignment in Pakistan you were given a new assignment to Turkey. On December 1, 2008, you and your family returned to the United States for a month's vacation. On January 2, 2009, you arrived in Turkey for your new assignment. Because you did not interrupt your bona fide residence abroad, you meet the bona fide residence test.
Physical Presence TestYou meet the physical presence test if you are physically present in a foreign country or countries 330 full days during a period of 12 consecutive months. The 330 days do not have to be consecutive. Any U.S. citizen or resident alien can use the physical presence to qualify for the exclusions and the deduction.
The physical presence test is based only on how long you stay in a foreign country or countries. This test does not depend on the kind of residence you establish, your intentions about returning, or the nature and purpose of your stay abroad.
330 full days. Generally, to meet the physical presence test, you must be physically present in a foreign country or countries for at least 330 full days during a 12-month period. You can count days you spent abroad for any reason. You do not have to be in a foreign country only for employment purposes. You can be on vacation.
You do not meet the physical presence test if illness, family problems, a vacation, or your employer's orders cause you to be present for less than the required amount of time.
Exception. You can be physically present in a foreign country or countries for less than 330 full days and still meet the physical presence test if you are required to leave a country because of war or civil unrest.
Full day. A full day is a period of 24 consecutive hours, beginning at midnight.
Travel. When you leave the United States to go directly to a foreign country or when you return directly to the United States from a foreign country, the time you spend on or over international waters does not count toward the 330-day total.
Example. You leave the United States for France by air on June 10. You arrive in France at 9:00 a.m. on June 11. Your first full day of physical presence in France is June 12.
Passing over a foreign country. If, in traveling from the United States to a foreign country, you pass over a foreign country before midnight of the day you leave, the first day you can count toward the 330-day total is the day following the day you leave the United States.
Example. You leave the United States by air at 9:30 a.m. on June 10 to travel to Kenya. You pass over western Africa at 11:00p.m. on June 10 and arrive in Kenya at 12:30 a.m. on June 11. Your first full day in a foreign country is June 11.
Change of location. You can move about from one place to another in a foreign country or to another foreign country without losing full days. If any part of your travel is not within any foreign country and takes less than 24 hours, you are considered to be in a foreign country during that part of travel.
Example 1. You leave Ireland by air at 11:00 p.m. on July 6 and arrive in Sweden at 5:00 a.m. on July 7. Your trip takes less than 24 hours and you lose no full days.
Example 2. You leave Norway by ship at 10:00 p.m. on July 6 and arrive in Portugal at 6:00 a.m. on July 8. Since your travel is not within a foreign country or countries and the trip takes more than 24 hours, you lose as full days July 6, 7, and 8. If you remain in Portugal, your next full day in a foreign country is July 9.
In United States while in transit. If you are in transit between two points outside the United States and are physically present in the United States for less than 24 hours, you are not treated as present in the United States during the transit. You are treated as traveling over areas not within any foreign country.
How to figure the 12-month period. There are four rules you should know when figuring the 12-month period.
- Your 12-month period can begin with any day of the month. It ends the day before the same calendar day, 12 months later.
- Your 12-month period must be made up of consecutive months. Any 12-month period can be used if the 330 days in a foreign country fall within that period.
- You do not have to begin your 12-month period with your first full day in a foreign country or end it with the day you leave. You can choose the 12-month period that gives you the greatest exclusion.
- In determining whether the 12-month period falls within a longer stay in the foreign country, 12-month periods can overlap one another.
Example 2. You work in New Zealand for a 20-month period from January 1, 2007, though August 31, 2008, except that you spend 28 days in February 2007 and 28 days in February 2008 on vacation in the United States. You are present in New Zealand 330 full days during each of the following two 12-month periods: January 1, 2007 - December 31, 2007 and September 1, 2007 - August 31, 2008. By overlapping the 12-month periods in this way, you meet the physical presence test for the whole 20-month period.
Foreign Earned Income ExclusionIf your tax home is in a foreign country and you meet the bona fide residence test or the physical presence test, you can choose to exclude from your income a limited amount of your foreign earned income.
You can also choose to exclude from your income a foreign housing amount.
If you choose to exclude foreign earned income, you cannot deduct, exclude, or claim a credit for any item that can be allocated to or charged against the excluded amounts. This includes any expenses, losses, or other normally deductible items allocable to the excluded income.
Limit on Excludable Amount
You may be able to exclude up to $91,500 of your foreign earned income in 2010. You cannot exclude more than the smaller of:
- $91,500, or
- Your foreign earned income for the tax year minus your foreign housing exclusion.
Part-year exclusion. If the period for which you qualify for the foreign earned income exclusion includes only part of the year, you must adjust the maximum limit based on the number of qualifying days in the year. The number of qualifying days is the number of days in the year within the period on which you both:
- Have your tax home in a foreign country, and
- Meet either the bona fide residence test or the physical presence test.
Foreign Housing Exclusion and DeductionIn 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 housing exclusion applies only to amounts considered paid for with employer-provided amounts. The housing deduction applies only to amounts paid for with self-employment earnings. We discuss the Foreign Housing Exclusion and Deduction in detail on a separate page of our site.