Not everyone who pays taxes in the U.S. lives and works on American soil. If you don’t, you may be able to exclude all or part of your foreign-source wages and self-employment income from U.S. federal income tax. The Internal Revenue Code provides for something called the foreign earned income exclusion, but numerous rules apply.
You must work and reside outside the U.S. and meet either the Bona Fide Resident or Physical Presence test.
The Bona Fide Residence Test
You’re considered a “bona fide resident” of a foreign country if you reside in that country for “an uninterrupted period that includes an entire tax year.” A tax year is January 1 through December 31, so the qualifying period for the bona fide residence test must include one full calendar year.
Brief trips or vacations outside the foreign country won’t jeopardize your status as a bona fide resident as long as the trips are brief and you clearly intend to return to the foreign country. You can even make brief visits to the U.S.
You’re not considered a bona fide resident of a foreign country if you’ve submitted a statement to that country indicating that you’re not a resident and the government there has determined that you’re not subject to their tax laws.
In other words, there’s no double dip. Your income cannot be excluded both in the foreign country and in the U.S.
Special treatment of income under an income tax treaty doesn’t prevent you from meeting the bona fide residence test.
The Physical Presence Test
You’re considered physically present in a foreign country if you reside there for at least 330 full days in any consecutive 12-month period.
You can live and work in any number of foreign countries, but you must be physically present in those countries for at least 330 full days. A “full day” is 24 hours, so the days of arrival in and departure from a foreign country generally don’t count toward the physical presence test.
The qualifying period can occur in any consecutive 12-month period, so this rule is a bit more lenient and may be easier to meet than the Bona Fide Residence Test.
You don’t have to begin your qualifying period with your first day in a foreign country. You can choose which 12-month period to use. This gives you the freedom to choose a 12-month period that provides the greatest income exclusion. Both vacation days and business days spent in the foreign country count toward meeting the 330-day threshold. Travel outside the country generally will not jeopardize the 330-day requirement.
Waiver Due to Adverse Conditions
The minimum time requirements for both the bona fide and physical presence tests can be waived, but only if you’re forced to leave the foreign country because of “war, civil unrest or similar adverse conditions.” You should be able to prove that you would have met the time requirements if these adverse conditions hadn’t interrupted your residence.
Types of Income to Which the Exclusion Applies
The foreign earned income exclusion applies only to income resulting from performing services as an employee or as an independent contractor. Earned income means salaries, wages, professional fees and other amounts received as compensation for personal services. Self-employment income can qualify for the foreign earned income exclusion.
From Which Tax is Income Excluded?
The foreign earned income exclusion excludes earned income from the federal income tax. Other types of income cannot be excluded using this provision. The exclusion does not reduce the self-employment tax, the mechanism by which self-employed persons pay in their Social Security and Medicare taxes.
How does the Exclusion Impact the Tax Calculation?
Taxpayers claiming the foreign earned income exclusion will pay tax at the rate that would have applied had they not claimed the exclusion.
In other words, the federal income tax is calculated by first figuring the amount of income tax on your total income before taking the foreign earned income exclusion. Then you can subtract the tax as calculated on the amount of foreign earned income that is excluded. The result is the amount of your federal income tax liability. You can use the Foreign Earned Income Tax Worksheet found in the Instructions for Form 1040 if you need help.
The Maximum Exclusion
The amount of foreign wages and salary a taxpayer can exclude each year is limited to actual foreign earned income or the annual maximum dollar limit, whichever is less. The foreign earned income exclusion has been adjusted each year for inflation by the Internal Revenue Service since 2006. The exclusion is $102,100 for the 2017 tax year. If you have foreign income from previous years, the limits were:
|Maximum Foreign Earned Income Exclusion|
|2016||$101,300||Revenue Procedure 2015-53 (PDF)|
|2015||$100,800||Revenue Procedure 2014-61 (PDF)|
|2014||$99,200||Revenue Procedure 2013-35 (PDF)|
|2013||$97,600||Revenue Procedure 2012-41 (PDF)|
|2012||$95,100||Revenue Procedure 2011-52 (PDF)|
|2011||$92,900||Revenue Procedure 2010-40 (PDF)|
|2010||$91,500||Revenue Procedure 2009-50 (PDF)|
|2009||$91,400||Revenue Procedure 2008-66 (PDF)|
|2008||$87,600||Revenue Procedure 2007-66 (PDF)|
|2007||$85,700||Revenue Procedure 2006-53 (PDF)|
|2006||$82,400||Revenue Procedure 2006-51 (PDF)|
|2002 through 2005||$80,000||Internal Revenue Code section 911|
|2001||$78,000||Internal Revenue Code section 911|
|2000||$76,000||Internal Revenue Code section 911|
|1999||$74,000||Internal Revenue Code section 911|
|1998||$72,000||Internal Revenue Code section 911|
The Prorated Exclusion
Choosing any consecutive 12-month period to qualify for the foreign earned income exclusion under the physical presence test creates the possibility that the amount of the exclusion may have to be spread over two tax years. The amount of the maximum exclusion in a year may have to be prorated.
If you find you must do this, simply use the number of days you were physically present in the foreign country during the tax year. The exclusion is calculated by the ratio of the number of days you were physically present in the foreign county – the numerator – to the number of days in the year, which is the denominator. The pro-rated exclusion amount may not exceed the maximum allowable exclusion.
You might also qualify for a prorated exclusion if you intended to meet all the time requirements but you left the country due to civil unrest.
The Housing Exclusion
You might also be able to exclude amounts paid by your employer for housing. This includes any amounts paid directly to you or to someone else on your behalf for housing, rent, education for your children, or tax equalization “gross up” payments. You must meet the same time requirements under the Bona Fide or Physical Presence test.
The following expenses qualify for the foreign housing exclusion:
- Fair rental value of housing provided by the employer
- Utilities other than telephone
- Real property and personal property insurance (homeowners and renters insurance)
- Occupancy taxes
- Nonrefundable security deposits or lease payments
- Furniture rental
- Residential parking fees
You might also be eligible to exclude housing amounts paid by your employer, including:
- Tax equalization payments paid by your employer
- Education expenses for your dependent children
The following expenses do not qualify for the foreign housing exclusion:
- Lavish or extravagant expenses as determined by a person’s circumstances
- Deductible interest and taxes such as mortgage interest
- Costs of buying property such as principal payments on a mortgage
- Domestic labor such as maids and gardeners
- Pay television
- Home improvements
- Purchased furniture
- Depreciation of property or improvements
Combining the Exclusions
You can claim the foreign earned income exclusion, the foreign housing exclusion, or both, but the same income cannot be excluded twice.
It’s usually more advantageous to use the foreign housing exclusion if your foreign earned income exceeds the maximum amount of the foreign earned income exclusion amount. The housing exclusion is 16 percent of the foreign earned income exclusion amount, or $16,336 for 2017.There are higher maximum amounts for selected foreign locations. The IRS lists the housing exclusion amounts in an appendix to the Instructions for Form 2555.
Foreign Housing Deduction for Self-Employed Taxpayers
Self-employed persons working abroad don’t qualify for the foreign housing exclusion, but they can deduct allowable housing expenses under the foreign housing deduction. This deduction can be calculated on IRS Form 2555 Part VI and IX. The foreign housing deduction reduces federal income tax, but won’t reduce your self-employment tax.