Foreign Earned Income
Citizens of the United States and resident aliens must pay taxes on their worldwide income regardless of where they are living. However, citizens and resident aliens living abroad are afforded certain “tax breaks” for income earned in foreign countries. The rationale is that those who are not present in the United States and do not have the opportunity to enjoy the benefits of the government’s taxation efforts should not have to share the same tax burden as those who live here year in and year out. The available tax breaks come in the form of relatively simple exclusions and deductions which may be claimed on IRS Form 2555. However, a complicated test exists for determining who qualifies for these exclusions and deductions.
Filing Requirements for Citizens and Resident Aliens Living Abroad
The rules for filing income taxes are generally the same whether you are in the US or in a foreign country. Your gross income, filing status, and age generally determine whether you must file an income tax return. The IRS updates the minimum income requirements regularly. For purposes of determining whether or not there is a filing requirement, gross income must also include any income that one plans on getting excluded under foreign earned income rules. All the same rules apply regarding due dates, extensions, and estimated taxes as well.
The amounts reported on your U.S. tax return must be expressed in U.S. dollars. If you are paid (in whole or in part) in foreign currency, you must translate it into U.S. dollars on your return. If you pay expenses (in whole or in part) in foreign currency, you must translate it into U.S. dollars on your return. The exchange rate that should be used is the prevailing rate at the time the income is received or the expense is incurred. If you owe taxes on your return, you must also pay what you owe in U.S. dollars. If your income is “blocked” or otherwise not readily convertible, you have two options: (1) you can report the full income and pay with other available U.S. dollars, or (2) you can postpone the reporting of the income until it becomes “unblocked.” The second option necessitates the filing of an additional “information return” with your tax return. Income becomes unblocked when it becomes converted or convertible.
Foreign address filers may e-file. This is still the method that the IRS prefers. However, if they decide to mail in a paper return, it should be sent to the Austin, Texas service center for processing. Residents of U.S. territories are generally required to file with the particular territory, not with the United States.
IRS Requirements for Claiming the Foreign Earned Income Exclusion and the Foreign Housing Exclusion/Deduction
The tax breaks available to foreign income earners are: the Foreign Earned Income Exclusion, the Foreign Housing Exclusion, and the Foreign Housing Deduction. In order to claim any of these, your tax home must be in a foreign country, you must have foreign earned income, and you must meet the requirements of the bona fide residence test or the physical presence test. This is where the rules become convoluted and difficult to apply.
1. Tax Home in Foreign Country
Your tax home is the general area of your place of business or employment, regardless of where you maintain your family home. It is the place where you are permanently or indefinitely engaged to work and is not necessarily the same as your residence or domicile for tax purposes. The location of your tax home often depends on whether your assignment is temporary or indefinite. It also depends on the specific actions you take that reflect your intent to remain in that foreign location.
A “foreign country” includes any territory under the sovereignty of a government other than that of the United States, including that country’s airspace and territorial waters. Excluded from the definition of “foreign country” are Antarctica and any of the U.S. possessions.
2. Bona Fide Residence Test / Physical Presence Test
Bona Fide Residence Test
To qualify under this test, you must be a U.S. Citizen or resident alien who is also a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year. Whether or not an individual is considered a bona fide resident depends on all the facts and circumstances. The IRS makes this determination based on what is reported on Form 2555. Some of the factors that the IRS considers are intention, purpose of trip, and nature/length of stay.
Physical Presence Test
To qualify under this test, you must be a U.S. Citizen or resident alien who is physically present in a foreign country for 330 full days during a period of 12 consecutive months. The 330 days do not have to be consecutive. This test is based entirely on how long you stay rather than your intentions and actions while you are there.
Exceptions to the Minimum Time Requirements
There are two exceptions to the minimum time requirements of the Bona Fide Residence Test and the Physical Presence Test. One exception is for war, civil unrest, and other adverse conditions. The IRS is supposed to publish which countries fall into this category for any given tax year. If the taxpayer can show that the minimum time requirement would have been met but for the adverse conditions present, then the time requirement is waived. The other exception has to do with U.S. travel restrictions. If you are present in a foreign country in violation of U.S. law then you will not be afforded the tax benefits no matter how long you stayed there.
3. Foreign Earned Income
Once the first two elements are met, it is easy to apply the “foreign earned income” requirement – it is simply any income you receive for services you perform while your tax home is in a foreign country and while you meet either the bona fide presence test or the physical presence test. Of course one also has to make sure that the income is in fact earned. Earned income is defined as “pay for personal services performed.” Earned income includes salaries, wages, commissions, etc. By law, foreign earned income does not include any amounts paid by the United States or any of its agencies to its employees.
Foreign Earned Income Exclusion
If you qualify under the rules above, you may exclude $91,500 of your foreign earned income when filing your taxes. That figure will be adjusted upward for tax year 2011. For married individuals, each spouse may claim this exclusion (for a total of $183,000) if each meets one of the above tests.
Foreign Housing Exclusion and Deduction
If you qualify under the rules above, you may also claim an exclusion or a deduction from gross income for your “housing amount.” Your housing amount is the total of your housing expenses for the year minus the base housing amount. The base housing amount is calculated by taking 16% of your foreign earned income exclusion. This exclusion can be a relatively small figure in the end. For example, if the tax year in question is 2008 then the maximum foreign earned income exclusion is $87,600. 16% of this amount is $14,016. If you spent a total if $15,500 for housing during 2008 then your housing amount is only $1,484 ($15,500 – $14,016). The exclusion amount should be prorated based on the number of days during your qualifying period and it is also capped at 30% of the maximum foreign earned income exclusion.
The foreign housing deduction is for those with self-employment income. Calculation of the foreign housing deduction depends on whether you have only self-employment income or both self-employment income and employer-provided income.
Exemptions, Deductions, and Credits
In addition to the tax breaks discussed above, U.S. citizens living abroad are also allowed all the same exemptions, deductions, and credits as citizens and residents living in the United States. However, if you choose to exclude foreign earned income or housing amounts, you cannot exclude, deduct, or claim a credit for any item that can be allocated to or charged against the excluded amounts. In other words, you may not benefit from double exemptions or double deductions.