Foreign Earned Income Exclusion for U.S Expats
The Foreign Earned Income Exclusion (FEIE), which offers large tax advantages to US citizens or resident aliens who live and work overseas, is one of the most significant features in the US tax code.
Understanding and making use of this exclusion can significantly affect your tax obligations and financial situation as an expat.
Through the FEIE, qualified people can deduct a specific amount of their foreign-earned income from their federal income taxes in the United States, which will be discussed in this article.
Now, let’s jump in and talk more about FEIE!
What is the Foreign Earned Income Exclusion?
One of the most prominent tax perks available to American expats who file their US tax return from abroad is the Foreign Earned Income Exclusion (FEIE). Depending on the clause, this IRS-administered provision enables expats to significantly reduce (or even completely eliminate) their US tax liability.
Elected on IRS Tax Form 2555, this largest source of tax benefits for US expats aims to avoid double taxation by exemption of income taxed in another country from U.S. taxation.
Who qualifies for the Foreign Earned Income Exclusion?
To be eligible for the foreign-earned income exclusion, an individual must meet these requirements:
Test for Foreign Residency: You must be an American citizen or resident alien who has resided abroad for a minimum of 330 days within a consecutive 12-month period. The 330 days do not need to fall within a calendar year.
Test of Bona Fide Residence: If you are unable to pass the Foreign Residency requirement, you may still be eligible for the FEIE by establishing a "bona fide residence" abroad. This indicates that you are genuinely residing there and intend to do so for a considerable amount of time.
The length and character of your visit, your objectives, and the emergence of social and business ties while you were overseas are all factors that affect the "bona fide residence" qualification.
Foreign Earned Income: The income you want to qualify for tax exclusion must have been acquired as payment for services rendered by you personally abroad. This covers pay from self-employment as well as wages, salaries, and professional fees. Dividends, interest, and rental income are examples of passive income that is not eligible for the FEIE.
Tax Home in a Foreign Country: You are required to have a tax home abroad. Regardless of your familial or personal links, your regular or major place of business, job, or post of service is often regarded as your tax home.
How to determine which test to use to qualify for the Foreign Earned Income Exclusion?
There are different tests to determine eligibility for foreign-earned income exclusion.
Here's a description of each test and guidelines to help you choose the appropriate one:
Physical Presence Test: For the 12-month duration, you must be physically present in one or more foreign countries for a predetermined amount of time. You must fulfill the requirements listed below in order to pass this test:
During any successive 12-month period, you must be physically present in a foreign country for at least 330 complete days.
Anytime throughout the tax year, the 12-month period can start.
The 12-month term need not coincide with the calendar year.
Count the days you were physically present in a foreign country to see if you passed the physical presence test. It's crucial to remember that a "day" is a whole 24-hour period that begins at midnight. You can keep track of your days by keeping a travel journal or using a calendar.
Bona Fide Residence Test: This is designed to determine whether you are truly residing in a foreign country. You must meet the following criteria in order to pass this test:
You must be a U.S. citizen or a resident immigrant.
You must legitimately reside in a foreign country.
You must have lived there continuously for the whole tax year, which is typically from January 1 to December 31.
Your goals, behaviors, and connections to the other nation must all be evaluated subjectively in order to determine if you meet the Bona Fide Residence Test.
To establish a legitimate residence, several factors must be considered, including:
Location of your primary residence: Having a stable and long-term place of residence in a foreign country indicates your intention to establish a genuine residence.
Ties to family and friends: Strong connections with family members and friends in a foreign country can demonstrate your commitment to building a lasting residence there.
Involvement in social and professional activities: Engaging in social and professional activities within the local community showcases your integration and commitment to being a part of the foreign society.
Length and nature of your stay: Staying in a foreign country for an extended period and maintaining a continuous presence further substantiates your intention to establish a legitimate residence.
These factors collectively contribute to demonstrating that you genuinely intend to create a bona fide residence in a foreign country.
What form should I use to apply for the Foreign Earned Income Exclusion?
Expats must file IRS Form 2555 along with their federal tax return to obtain the tax benefit of the Foreign Earned Income Exclusion.
It has nine sections:
Section I is where you’ll input personal details, your employer’s details (if applicable), and where your tax home is
Section II is for expats who meet the Bona Fide Residence Test
Section III is for expats who meet the Physical Presence Test
Section IV is for your earned income and expense details, which should correspond with the figures you enter in Form 1040
Sections V & VI relate to the Foreign Housing Exclusion/Deduction
Sections VII-IX are where you’ll enter the final figures used to calculate the total amount you’ll be excluding
How do I claim the Foreign Earned Income Exclusion?
To claim these benefits, you must have foreign-earned income, your tax home must be in a foreign country, and you must meet the requirements discussed earlier to be qualified for the Foreign Earned Income Exclusion.
What is the maximum amount of income that can be excluded with the Foreign Earned Income Exclusion?
The FEIE cap is $112,000 for the 2022 tax year. The FEIE limit will rise to $120,000 in the 2023 tax year (Filed in 2024).
The amount of the FEIE is updated each year to account for inflation. This can cause confusion because early forecasts of the new FEIE limit may underestimate or exceed the permitted excludable amount.
How does the Foreign Tax Credit differ from the Foreign Earned Income Exclusion?
While the Foreign Tax Credit can be applied to both earned and unearned income, the Foreign Earned Income Exclusion is only relevant to earned income.
Pay for personally rendered services, such as salary and wages, commissions, bonuses, and self-employment revenue, are all considered forms of earned income.
Investment-type income, such as capital gains, dividends, and taxable interest, is referred to as unearned income. In addition, it covers alimony, pensions, annuities, and other retirement income.
What is the filing deadline for U.S. expats to claim the Foreign Earned Income Exclusion?
The automatic 2023 tax deadline for American residents and Green Card holders filing from abroad is June 15, 2023. This deadline extension is automatic, as the name suggests, so no request is necessary.
The second deadline extension is October 16, 2023. It is available to American expats only if they submit an official request using IRS Form 4868 before the June 15th deadline. The deadline is typically October 15th, but in 2023 it was moved up a day to take into account the fact that it falls on a Sunday.
Americans who reside overseas occasionally could need yet another extension. In order to be eligible to request the December extension, those who are still unable to fulfill the October 16th deadline must still ask for the October extension.
The second extension, if properly requested and approved, enables US citizens living abroad to file their tax returns up until December 15, 2023, without incurring any penalties.
What are some common problems U.S. expats encounter with the Foreign Earned Income Exclusion and Form 2555?
When filing their FEIE, U.S. expats frequently have the same inquiries and problems, although the following are the most typical issues:
You failed to submit Form 2555: A lot of expats believe that if they are eligible for the FEIE, the information will be immediately added to their tax return. Form 2555 must be filed in order to claim the FEIE.
You work for the government: Sadly, U.S. government personnel are not eligible for this overseas income exclusion.
You made a mistake in your FEIE calculation: Calculating your FEIE incorrectly will prevent you from getting the correct amount excluded.
You filed the FEIE when you should have filed the FTC: For instance, if you are retired abroad and your only sources of income are investments and passive income, filing with the FTC may have been preferable.
You didn't track your time effectively. If you want to pass the Physical Presence or Bona Fide Residency examinations, you must be diligent about timekeeping.
You had no active income during that year: If you are relying on investments or passive income to support yourself while living abroad, you are ineligible for the FEIE.
You failed to pay your self-employment tax in the US: When claiming the FEIE, self-employment tax is still due.
These are just a few of the challenges and issues that US expats encounter most frequently.
If you're having trouble doing it, leave your expat taxes to Compass CPA PC today!
What other tax benefits are available to U.S. expats to reduce their tax liability?
Aside from FEIE, there are instances where US expats can reduce their tax liability.
Listed below are the options
:
Check for US tax treaties: Avoid double taxation in select countries
You might be able to avoid paying taxes twice if you live in a place where the US and another country have a tax treaty.
Due to US tax agreements with other nations, US expats can avoid paying double taxes on their worldwide income. As a result of these agreements, certain foreign citizens' federal income taxes on profits derived from non-US sources are reduced or waived.
Claim Foreign tax credit: Skip some US taxes you paid to a foreign country
Americans who work overseas might lower their US tax obligations thanks to the foreign tax credit (FTC). US citizens can claim a credit and save on their US tax filing by having already paid income tax to a non-US nation.
How does the FTC work?
The FTC is uncomplicated. Suppose you owe $1,000 (USD) in income taxes to the US, but you have already paid $500 in taxes to your home nation. Your total tax obligation to the US government will be $500; however, you are eligible for a foreign tax credit of $500.
Your overseas income and the foreign income tax you have previously paid will determine how much credit you receive.
Claim foreign housing exclusion/deduction: Save on rental costs while living abroad
Foreign housing exclusions and deductions, as the name implies, allow US citizens living overseas to exclude and write off their housing expenses. On their US federal tax return, these expenses are excluded or subtracted from the US taxpayer's gross income.
In addition to FEIE, expats are also entitled to foreign housing exclusions and deductions. However, they cannot claim an FTC for excluded, unpaid, or deducted amounts.
When should I consider electing or revoking the Foreign Earned Income Exclusion, and what are the potential consequences?
The Foreign Earned Income Exclusion (FEIE) is a tax benefit that you can elect to keep or remove depending on your personal situation. Through the FEIE, qualifying American citizens and resident aliens can exclude a portion of their foreign-earned income from federal taxation in the United States.
Considerations for electing or revoking the FEIE include the following:
Eligibility: You must pass either the Physical Presence Test or the Bona Fide Residence Test in order to be eligible for the FEIE. For the Physical Presence Test, you must spend at least 330 full days in a foreign country over the course of a year. Your intention to live permanently in a foreign nation is taken into account by the Bona Fide Residence Test. Determine whether you are qualified to take either test.
Income and Tax Rates: Assess your foreign-earned income and compare it to the FEIE limit using the income and tax rates. The FEIE cap for the 2023 tax year is $120,000 (inflation-adjusted annually).
If you meet the eligibility requirements and have income below this threshold, you may be able to avoid paying federal income taxes in the United States on your foreign-earned income by choosing the FEIE option.
However, it can be more advantageous to revoke the FEIE and take advantage of the foreign tax credit or other tax benefits if your income exceeds the cap or you have considerable deductions or credits.
Long-term plans: Take into account your long-term objectives and the likely length of your stay in the foreign nation.
Making the FEIE your choice could result in continued tax savings if you plan to go abroad for an extended period of time or establish yourself as a legitimate resident of another nation. If you intend to stay in the country permanently or if your situation changes, revoking the FEIE might be a better option.
Impact on Social Security: Choosing the FEIE may have an impact on your ability to receive Social Security benefits. A minimum of 40 credits, or the equivalent of 10 years of labor, are normally required to be eligible for Social Security retirement, disability, or survivor benefits.
If you don't include overseas earned income on your U.S. tax return, you might not accrue the necessary Social Security credits. This might have an impact on your eligibility and benefit calculations in the future.
Bottom Line
For Americans living abroad, the Foreign Earned Income Exclusion presents a beneficial chance to lower their tax obligations on foreign-earned income.
Moreover, you can take advantage of the financial advantages this provision offers by being aware of the eligibility standards and making efficient use of them.
This will free you up to concentrate on embracing novel experiences and succeeding in your international endeavors.
Got no clue where to start? Compass CPA PC is here to help make the process easier since navigating the complexities of U.S. tax regulations can be challenging.
Book an appointment with us now!