The Foreign Earned Income Exclusion
Exclude foreign wages from U.S. taxes using Form 2555
Not everyone who pays taxes in the U.S. lives and works on American soil. If you reside outside the U.S., you may be able to exclude all or part of your foreign-source wages and self-employment income from U.S. federal income tax with the foreign earned income exclusion. To qualify for the exclusion, you'll need to meet a number of criteria.
You must work and reside outside the U.S. and meet either the bona fide resident or physical presence test.
If you do, you're eligible to exclude up to $104,100 in foreign earned income for the 2018 tax year. The amount of the exclusion often increases each year.
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.
Trips or vacations outside the foreign country won't jeopardize your status as a bona fide resident, as long as the trips are short and you clearly intend to return to the foreign country where you were living. 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, which gives you the freedom to choose the period providing the greatest income exclusion. Vacation days and business days spent in the foreign country both count toward meeting the 330-day threshold. Travel outside the country generally does not jeopardize the 330-day requirement.
Waiver Due to Adverse Conditions
The minimum time requirements for both the bona fide residence 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 but doesn't reduce the self-employment tax—the mechanism by which self-employed persons pay in their Social Security and Medicare taxes.
How the Exclusion Affects the Tax Calculation
If you claim the foreign earned income exclusion, you will pay tax at the rate that would have applied had you 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.
You subtract the tax as calculated on the amount of foreign earned income that is excluded. The result is your federal income tax liability amount. 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. Since 2006 the Internal Revenue Service has annually adjusted for inflation the foreign earned income exclusion The exclusion is $104,100 for the 2018 tax year.
The Prorated Exclusion
Choosing any consecutive 12-month period to qualify for the foreign earned income exclusion under the physical presence test means that you may have to spread the exclusion amount over two tax years. You may have to pro-rate the maximum exclusion in a year.
Use the number of days you were physically present in the foreign country during the tax year to pro-rate the maximum exclusion. Calculate 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 pro-rated exclusion if you intended to meet all the time requirements but left the country due to civil unrest.
The Housing Exclusion
You might also be able to exclude amounts your employer paid you 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 residence or physical presence tests.
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: $16,624 for 2018. 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 Parts VI and IX. The foreign housing deduction reduces federal income tax, but won't reduce your self-employment tax.