In today's globalized world, many Americans are living and working abroad. However, the US tax system requires citizens and permanent residents to file US tax returns regardless of their physical location. This may result in double taxation for expats, as they may be subject to taxation in their country of residence and the US. Thankfully, provisions are in place to help avoid this, one of the most important being the Foreign Earned Income Exclusion (FEIE).

The Foreign Earned Income Exclusion (FEIE) is an IRS exemption that allows American expats to exclude a certain amount of their foreign-earned income from US taxation. This provision aims to prevent double taxation by providing relief for expats already paying taxes on their income in their country of residence. The amount that can be excluded through the FEIE has been adjusted annually for inflation. As of the 2023 tax year, the maximum exclusion amount is $120,000.

What is considered foreign-earned income?

It is important to understand what is considered foreign-earned income that qualifies for the FEIE. Foreign-earned income includes wages, salaries, commissions, bonuses, tips, self-employment income, and professional fees earned through work or services in a foreign country. Foreign-earned income does not include passive-type income, like dividends, interest, or rental income.

Qualifying for the Foreign Earned Income Exclusion

To qualify for the FEIE, you must meet specific requirements set by the IRS. You must pass at least one of the following two tests to determine eligibility.

1. Physical Presence Test

The Physical Presence Test requires you to be physically present in a foreign country for at least 330 full days during a 12-month period. This period does not have to coincide with the calendar or tax year. By meeting this test, you can demonstrate that you have a tax home in a foreign country and are eligible for the FEIE.

2. Bona Fide Residence Test

The Bona Fide Residence Test is based on establishing your bona fide residency in a foreign country. To pass this test, you must demonstrate that you have established a permanent residence in a foreign country and have no immediate plans to return to the US. This can be proven through various factors, such as obtaining a permanent residency visa, having a home in a foreign country, and maintaining ties to the local community.

How to Claim the Foreign Earned Income Exclusion

To claim the FEIE, you must file IRS Form 2555 along with your US tax return. This form allows you to report your foreign-earned income and calculate the amount that can be excluded from your taxable income. It's essential to keep thorough records and documentation to support your claim, including proof of your physical presence or bona fide residence in a foreign country.

Foreign Housing Exclusion/Deduction

In addition to the FEIE, you may also be eligible for the Foreign Housing Exclusion or Deduction. This provision allows you to exclude or deduct certain housing expenses paid with your foreign-earned income. Qualifying housing expenses can include rent, utilities, and other necessary expenses related to your housing abroad. The maximum exclusion or deduction amount for foreign housing is generally 30% of the FEIE.

Calculating the Foreign Earned Income Exclusion

Calculating the amount that can be excluded through the FEIE can be complex. It's crucial to understand the formula used to determine the exclusion amount and any limitations that may apply. For example, moving abroad part way through the year will require the maximum exclusion to be reduced and prorated.

The FEIE is calculated by multiplying the maximum exclusion amount by the ratio of your foreign-earned income to your total income. This ratio is then applied to your total US income tax liability to determine the amount of tax that can be excluded.

Example

Let's say you earned a $199,000 salary while working abroad, along with $1,000 in foreign bank interest. And, you qualify for the FEIE since you were out of the US for the entire calendar year. The current exclusion amount is $120,000 per person for the 2023 tax year.

To calculate the exclusion, you need to determine the percentage of your income that can be excluded. Divide the exclusion amount by your total income:

Exclusion Amount / Total Income = Exclusion Percentage

$120,000 / $20,000 = 60%

Now, multiply this percentage by your total income to calculate the excluded amount:

Exclusion Percentage * Total Income = Excluded Amount

60% * $200,000 = $120,000

In this example, you can exclude $120,000 from your taxable income, effectively reducing your US taxable income to $80,000. Note that only the salary income can be excluded, not the interest income. Foreign tax credits may then be claimed on the remaining $80,000 of income.

The FEIE is limited to your foreign-earned income minus any foreign housing exclusion or deduction you may claim. Additionally, the FEIE cannot be used to reduce your self-employment tax, so you still may end up having a tax liability on your US tax return even if the full exclusion applies.

State Taxes

While the FEIE can help reduce your US federal income tax liability, it may not necessarily apply to state taxes. Each state has its own tax laws and regulations, and some states may not recognize or allow the FEIE to be applied to state tax calculations. Alternatively, some states do not recognize foreign tax credits, so the FEIE could be a great way to reduce state taxes. It's helpful to consult with a tax professional or research the specific tax laws of your state to determine how the FEIE may apply to your state tax obligations.

Additional Considerations and Limitations

While the FEIE can be a valuable tool for reducing your US tax liability, it's essential to be aware of specific considerations and limitations.

Tax Treaty Benefits

If you are a US resident alien or citizen of a country with which the US has an income tax treaty, you may be eligible for additional tax treaty benefits. These benefits can provide further relief from double taxation and may impact your eligibility for the FEIE. Review the specific provisions of the tax treaty between your country of residence and the US to understand how it may affect your tax situation.

Reporting Requirements

Even if you qualify for the FEIE and exclude your foreign-earned income from US taxation, you are still required to file a US tax return and report your worldwide income. Accurately reporting your foreign income and complying with all reporting requirements can help you avoid potential penalties or audits.

Other Tax Benefits and Credits

In addition to the FEIE, other tax benefits and credits may be available to expats. For example, you may be eligible for the Foreign Tax Credit, which allows you to offset your US tax liability with foreign taxes paid. However, the FEIE and foreign tax credits cannot apply to the same income. You have to pick one or the other. Both benefits may be claimed on a return, but they cannot overlap with the same income.

The Foreign Earned Income Exclusion is valuable to help American expats avoid double taxation and reduce their US tax liability. By understanding the requirements, calculating the exclusion amount, and complying with reporting obligations, expats can use this provision to optimize their tax situation. However, it's important to seek the guidance of a tax professional to ensure you are maximizing your tax benefits while remaining compliant with US tax laws. If you have any questions, please contact us.