Not everyone who pays taxes in the U.S. lives and works on American soil. If you're a U.S. citizen or resident alien, you're responsible for paying income taxes—regardless of where that income was earned. However, taxpayers who live elsewhere might qualify for the foreign earned income exclusion, allowing them to exclude all or part of their foreign-source wages and self-employment income from U.S. federal income tax.
Those who qualify by meeting either the bona fide resident or physical presence test may be able to exclude up to $107,600 in foreign earned income in the 2020 tax year. (This increases to $108,700 in the 2021 tax year.)
Here's how to tell whether you qualify.
Bona Fide Residence Test
You're considered a bona fide resident of a foreign country if you reside in that country for a period that includes an entire tax year. Because a tax year is January 1 through December 31, the qualifying period for the bona fide residence test must include at least one full calendar year. Trips or vacations outside the foreign country won't jeopardize your status as a bona fide resident, as long as they 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 it tax laws. Your income can't be excluded from taxation in both the foreign country and the U.S. Special treatment of income under an income tax treaty doesn't prevent you from meeting the bona fide residence test.
Physical Presence Test
You're considered to be physically present in a foreign country if you reside there for at least 330 qualifying full days in any consecutive 12-month period that at least partially includes the tax year in question. A full day is 24 hours, so the days of arrival and departure from a foreign country don't count toward the physical presence test. This rule is a bit more lenient and may be easier to satisfy than the bona fide residence test, because the qualifying period can occur in any consecutive 12-month period, not necessarily a single calendar year.
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, and travel outside the country generally does not jeopardize the 330-day count.
Waiver Due to Adverse Conditions
The minimum time requirements for both the bona fide residence and physical presence tests can be waived 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 period.
Eligible Income Types
The foreign earned income exclusion applies only to earned income resulting from performing services as an employee or as an independent contractor. Earned income includes salaries, wages, professional fees, and other amounts received as compensation for personal services.
Affect on the Tax Calculation
While this exclusion reduces your taxable income, you still pay taxes at the rate that would have applied had you not claimed the exclusion. In other words, your tax bracket stays the same, even if the exclusion ultimately lands your income in a lower bracket. Use the Foreign Earned Income Tax Worksheet found in the Instructions for Form 1040 if you need help.
Choosing any consecutive 12-month period to qualify for the foreign earned income exclusion under the physical presence test means that you might have to spread the exclusion amount over two tax years. You'd have to prorate the maximum exclusion in each year using the number of days you were physically present in the foreign country during the tax year. The prorated exclusion amount can't exceed the maximum allowable exclusion. You might also qualify for a prorated exclusion if you intended to meet all the time requirements but left the country due to civil unrest.
You may be able to exclude any amounts your employer paid you for housing—including money paid to you or directly to someone else on your behalf—but you must meet the same time requirements under the bona fide residence or physical presence tests.
Only housing expenses paid by you or on your behalf (if your employer pays your rent directly to the landlord) qualify for this tax break, and the housing accommodations must be reasonable. Any lavish or extravagant costs won't qualify, nor will costs like buying furniture or renovating the home in a way that will permanently increase its value. If you buy property abroad, the cost of purchasing it does not qualify.
You might also be eligible to exclude other amounts paid by your employer, including tax equalization payments and education expenses for your dependent children.
Self-employed people working abroad don't qualify for the foreign housing exclusion, but they can deduct allowable housing expenses under the foreign housing deduction. If a U.S. citizen living abroad is both self-employed and employed by an employer, they may be eligible for both a foreign housing exclusion and a foreign housing deduction.
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. If your foreign earned income exceeds the exclusion amount, it may be more advantageous to use the foreign housing exclusion. The housing exclusion is 16% of the foreign earned income exclusion amount divided by 365 (366 during leap years), then multiplied by your qualifying days during that tax year. There are daily and annual limits on housing expenses that qualify for deductions and exclusions, but they vary by country (and sometimes by city). You'll have to check the Instructions for Form 2555 to see the relevant limits for your situation.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.