The Foreign Earned Income Exclusion - who's it for, how it works, and how to claim it
Contributed by Bright!Tax
Americans living abroad are uniquely unfortunate among expats in that they still have to file a tax return to their home country.
This is because the US taxes on citizenship, rather than on residence like most other countries. This in turn means that all US citizens (and green card holders) are required to file a US tax return, and pay US taxes, wherever in the world they live or earn.
Thankfully though, there are some exclusions available for expats that reduce or in many cases eradicate their US tax liability. The primary of these exclusions for expats is the Foreign Earned Income Exclusion.
Who’s it for and how it works
The Foreign Earned Income Exclusion can be claimed by any American living abroad who meets certain conditions.
Chief among these conditions is the requirement to prove that you live abroad. You can do this with either the Bona Fide Residence Test, or the Physical Presence Test.
The Bona Fide Residence Test requires you to prove that you are a permanent resident in a foreign country. You can do this by providing utility bills from your home, for example, or bank statements, or foreign tax statements, or other proof of residence, such as a residency visa.
The Physical Presence Test meanwhile requires you to prove that you spent more than 330 days outside of the US in a 365 day period that coincides with the tax year. Note that you can only exclude income on the days that coincide with the tax year.
If you can prove that you live abroad using one of these two tests, you can claim the Foreign Earned Income Exclusion to exclude up to around $100,000 (the exact figure rises a little each year) of your income from US tax liability
It doesn’t matter whether your income is from employment or self-employment, or in which country it is sourced or paid, so long as you the tax payer can prove that you live abroad.
How to claim it
To claim the Foreign Earned Income Exclusion, you must file form 2555 along with your annual US tax return.
This is an important point to make, that the Foreign Earned Income Exclusion isn’t applied automatically, but has to be actively claimed, and a tax return still filed.
Form 2555 isn’t the most complex IRS form, but neither is it the simplest. If your situation is very straightforward though, you can use form 2555-EZ, an abbreviated version.
Don’t forget, as an expat you have until June 15th to file, while there’s a further extension available until October 15th that you can apply for online.
What happens if you earn over $100,000?
If you earn just a little over $100,000, you live in rented accommodation, and you can prove you live abroad using either the Physical Presence Test or the Bona Fide Residence Test, you can also exclude a proportion of your housing rental expenses by claiming the Foreign Housing Exclusion (or the Foreign Housing Deduction, if you’re self employed). There are fairly intricate rules and formulas governing which expenses you can claim and what proportion of them you can exclude depending where you live, however you will normally be able to exclude a further $15,000 to $30,000 of your income from US taxes.
The Foreign Housing Exclusion and Deduction can also be claimed on form 2555.
If you still earn more than you can claim using both the Foreign Earned Income Exclusion and the Foreign Housing Exclusion or Deduction, and you pay tax in a foreign country, you can consider claiming the Foreign Tax Credit.
The Foreign Tax Credit gives you a $1 tax credit for every dollar of tax you’ve paid abroad, and can be applied on income above the other exclusions that you’ve claimed (but not on the same income).
If you are paying more total tax abroad in total than you would owe to the US, it can be advantageous to only claim the Foreign Tax Credit, and not the Foreign Earned Income Exclusion, as this way you can claim more US tax credits than the US tax that you owe, so reducing their US tax liability to zero while also having excess tax credits that you can carry forward for use in the future.
What happens if you didn’t know that you were meant to file a US tax return?
Many American expats are unaware of the requirement for them to file a tax return from abroad, and so can find themselves not only behind with their filing but owing back taxes to the IRS, as they haven’t actively claimed the Foreign Earned Income or the Foreign Tax Credit.
Thankfully, there’s a way for people in this situation to catch up on their filing without facing penalties that still lets them claim these exclusions.
The Streamlined Procedure is an IRS amnesty program that requires expats who are behind with their tax filing to file their last 3 tax returns and their last 6 FBARs (in both cases, where appropriate), pay any back taxes due (often none, if they claim the Foreign Earned Income Exclusion as part of their tax returns), and self-certify that their previous failure to file was non-willful (I.e. not deliberate).
The Streamlined Procedure is a great opportunity for expats who are behind with their US tax filing to catch up.
Bright!Tax is a leading provider of US tax services to the estimated 9 million Americans living abroad. If you have any questions regarding your situation, don't hesitate to contact us and we'll be happy to help.
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