Residing and working outside the United States
As a U.S. citizen or resident alien having a tax home in a foreign country (i.e., place of business/employment permanently or indefinitely based in a foreign country) and meeting one of either of the below mentioned tests, you can elect “Foreign Earned Income Exclusion”. “Permanent” foreign assignment is defined for a period of more than one year. If your foreign assignment is less than one year and you do not qualify for the exclusion, the food and lodging expenses involved can be deducted or expense using form 2555 when filing tax returns with form 1040.
Individuals must meet one of two types of tests namely, Bona Fide Residence Test and Physical Presence Test in order to qualify for foreign earned income exclusion. Let’s understand each test in detail:
Bona Fide Residence Test
A bona fide resident is either a U.S citizen or a resident alien who is a citizen of a country which has an income tax treaty with the U.S. You qualify this test if you are a resident of a foreign country/countries for a continuous period covering at least one calendar tax year (i.e., Jan. through Dec.). The residence described here is temporary and you can return to your home country eventually. During the period of bona fide residency, brief vacation/business trips back to the U.S or other countries will not result in failure of this test.
Physical Presence Test
To meet this test, you must be physically present in a foreign country/countries for 330 full days during a period of 12 consecutive months. This period can run from any month or any day of any month covering 12 consecutive months thereon. You can also qualify for the current year by including overlapping days with the preceding 12 month period. For example, a 20-month period (Jan1st, 2018 to Aug 31st, 2019) can be broken down to 2 qualifying 12 month periods such as Jan1st, 2018 – Dec 31st, 2018 and Sept 1st, 2018 – Aug 31st, 2019. Here, overlapping months from 2018 are used to qualify for 2019.
What is foreign earned income exclusion amount?
The foreign earned income exclusion for 2019 is $105,900. If you satisfy the above requirements, you can exclude the lesser of (a) $105,900 – (indexed to inflation) or (b) your foreign earned income for the year (upon qualifying, exclusion for your spouse foreign income is separately determined). Exclusion applies only to foreign employment income NOT including pension/annuity payments or payments received as a U.S government employee.
Exclusion must be calculated on a daily basis if you do not satisfy tests for a year. Let’s look at an example: If you qualify for exclusion for the last 50 days of 2019 (followed by rest of 2020) under the bona fide residence test, then for 2019, the maximum exclusion is $14,507 (50/365 times $105,900). A similar computation of exclusion will be made if you qualify under the Physical Presence Test.
Foreign housing cost exclusion: This exclusion is eligible for payments made by an employer either on your behalf or as a reimbursement for incurred housing cost. This amount is taxable foreign earned income. (Availing this may in some cases offset your earned income exclusion).
Should I elect for foreign earned income exclusion?
1. Scenarios to elect for exclusion:
- As an employee expecting to work in a country with no employment tax or lower tax rate than the U.S.
- Involved in a profitable trade/business in a foreign country that has no corporation/business tax or has a lower tax rate than the U.S.
- In some cases, if foreign housing costs are covered by the employer.
2. Scenarios to NOT elect for exclusion:
- If you pay foreign tax rates that are higher than rates in the U.S and claiming foreign tax credit is preferable. This situation can apply to U.S. citizens or permanent residents living in Canada or most countries in Europe.
- A business in foreign country with has a net loss in the taxable year. By claiming foreign earned income exclusion, the effects of net loss will be reduced thus reducing the benefit of net loss to offset other worldwide income.
Also read The Delay of Tax Refunds in 2017