What is the foreign earned income exclusion?
If you are a U.S. citizen (or U.S. resident alien) who living in or planning to relocate to a foreign country you may qualify for what is known as the “Foreign Earned Income Exclusion”. The foreign earned income exclusion is an exception to the general rule that US citizens and resident aliens are taxed on their worldwide gross income, that is, you must pay US taxes on all of your income from everywhere, even if you live outside the US or have never been here. While the foreign earned income exclusion doesn’t help you when it comes to being taxed in the foreign country, it does mean that, if you qualify, you can exclude some of that income from what is taxed by Uncle Sam.
Are you a “qualified individual” for purposes of the foreign earned income exclusion?
There are a couple of tests you must pass in order to qualify for the Foreign Earned Income Exclusion.
Tax home
(1) You must have a “tax home” in a foreign country. An individual’s tax home is considered to be his regular or principal (if there is more than one regular) place of business. If the individual has no regular or principal place of business because of the nature of the business, or because he is not engaged in carrying on a trade or business, his tax home is his regular place of abode. In other words, you must either be conducting business abroad or have your home there. Additional rules apply to resident aliens claiming to have a tax home in their country of origin.
Bona fide resident and physical presence tests
(2) You must either be (i) a “bona fide foreign resident” of that country (only US citizens and US resident aliens who come from countries with which the US has a tax treaty can use this test) for an uninterrupted period that includes an entire “tax year”; or (ii) physically present in the foreign country for 330 full days during any consecutive 12 month period (in which case you are a “qualified individual”). Both US citizens and resident aliens can use this test.
Whether you are a “bona fide resident” of a foreign country depends on the facts and circumstances of why you are there. Part (though not all) of the analysis depends on where you are “domiciled”. Selling your home in Des Moines, for example, and purchasing a scenic villa in Punta Del Este, Uruguay, where you stay all year round and join the community, suggest that you could be a bona fide resident of Uruguay for purposes of the Foreign Earned Income Exclusion. The duration of your stay is also relevant. If it is clear that you have moved for an indefinite period of time and made yourself part of the community in the foreign country, you move closer to being a bona fide resident.
If, however, you are abroad for a limited purpose, say, if you are a contractor in country solely for a particular assignment, with the expectation that you will return to the US when it is done, this would weigh against your being a bona fide resident. The physical presence test is more straightforward than the residence test, but more rigid. It doesn’t matter why you are in the foreign country (or countries – so long as they’re not the US) so long as you are physically abroad for the 330 twenty-four hour periods. So, unlike the residence test you don’t have to worry about why you’re there, but you can’t come and go for more than 35 days (with no more than 30 being in any single month).
Calculating the foreign earned income exclusion on your taxes
Assuming you qualify under the tests described above, calculating your foreign earned income tax exclusion is unfortunately not as simple as hacking the yearly exemption amount ($100,800.00 for 2015) off the top of your gross income. Rather, you must first determine for how many days of the year in which you earned the foreign income you were a “qualified individual” (as described by the tests above). Second you then take that fraction and apply it to the maximum exclusion amount.
For example, assume that U.S. citizen Sarah’s tax home is in France where she meets the bona fide residence test for 2015. Sarah is a qualified individual for 181 days and receives $100,000 that is attributable to services she performs in France. Sarah can exclude $49,986 of foreign earned income, the lesser of $100,000 or $49,986 ($100,800 x 181/ 365). Sarah would then factor that excluded amount into her other income to come up with the amount of tax she owes.
A couple caveats about the foreign earned income exclusion. First, the calculations for determining the amount of tax due at the end of the day are very complex. Second, the character of the income (i.e. wage income versus capital gains) is relevant in some cases. Third, there are different rules that may apply if you are running a business abroad and have what would otherwise be deductible business expenses, versus serving abroad as an employee. It is very important to consult an international tax professional to understand how any foreign tax credit and/or the foreign housing cost exclusion (covered later) would apply and how you might benefit from this important way around being taxed twice by two different countries.