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Chapter 42
U.S. citizens working abroad: Tax treatment of foreign earned income

How To Qualify for the Foreign Earned Income Exclusion

You qualify for the foreign earned income exclusion if you are a U.S. citizen, you have a tax home in a foreign country, and you meet either the foreign residence test or the physical presence test, described below.

Generally, if you are a resident alien of the United States, you may qualify for the foreign earned income exclusion if you satisfy the physical presence test. This assumes that you continue your resident alien status while living outside the United States.

Tax home. Your tax home generally is the location of your principal place of employment, which may or may not coincide with the location of your family’s residence. Among the factors that are important in determining whether or not your tax home is outside the United States are the anticipated duration of your overseas assignment and whether or not you will return to the same employment location in the United States. Under IRS guidelines, an anticipated short-term (1 year or less) assignment overseas, followed by a return to the same place of employment in the United States, would indicate that you do not have a tax home outside the United States.

If you meet either the foreign residence test or the physical presence test (discussed below) and have a tax home outside the United States, you are eligible for two exclusions—the foreign earned income exclusion and the foreign housing exclusion. Self-employed individuals are eligible for a housing deduction rather than the housing exclusion (see the discussion later in this chapter).

Foreign residence test. The foreign residence test requires that you be a “bona fide resident” of a foreign country (or more than one foreign country) for an uninterrupted period that includes an entire tax year. Whether or not you are a bona fide resident is a subjective question. The answer is determined by the facts and circumstances of your particular situation, including the purpose of your trip and the nature and length of your stay abroad, and your intent.

The following factors are considered by the IRS in determining your intent to be a bona fide resident in a specific place.

The type of quarters you occupy (hotel or rooming house, rented quarters, purchased quarters, or quarters furnished by your employer)
How long your family resided with you during the tax year
The length of the uninterrupted period of time during which you have been living outside the United States
The nature of any conditions or limitations concerning your employment agreement and the type and term of your visa to live/work in the foreign country
Whether you maintain a home in the United States and, if so, its rental status and the relationship of any tenants to you

If you make a statement to the authorities of a foreign country that you are not a resident of that country, and if you are not subject to tax by that country, you do not qualify as a bona fide resident of that country.

Once you have met the foreign residence test for an entire tax year, your qualification is retroactive to the first day you established your bona fide residence. Occasional trips to the United States for business or vacation do not affect your qualification.

Example 1. You moved from the United States to a foreign country, arriving on September 15, 2017. You entered the country under a resident visa with your family for a 3-year assignment. You did not declare to the foreign authorities that you were not a resident of that country. You qualify as a bona fide resident of the foreign country if these facts remain the same through December 31, 2018. You may file your 2017 U.S. income tax return (or amend your original 2017 tax return) to claim the benefits of being a bona fide resident of a foreign country for the period September 15, 2017, through December 31, 2017.

Example 2. George has been a resident of the United Kingdom for 5 consecutive years. If he moves to France this year, he continues to be a bona fide resident of a foreign country. An uninterrupted period of bona fide residence may include residence in more than one foreign country in a given year.

Example 3. Amy moved to France with her family on June 15, 2016, for a job assignment of indefinite length. On December 3, 2017, she was transferred back to the United States. She did not satisfy the bona fide residence test in either year, since she did not maintain a bona fide residence in a foreign country for a period that includes a complete tax year. However, she may qualify for the foreign exclusions under the physical presence test (discussed below).

Physical presence test. This test simply requires that you be physically present in a foreign country (or countries) for 330 full days during any consecutive 12-month period. This is a purely objective test. There is no reference to your intentions or to any other factors that determine bona fide residence abroad.

Two important rules to keep in mind regarding this test are as follows:

A full day is a 24-hour period commencing at midnight. Thus, a day in which you travel to or from the United States is not a full day in a foreign country.
When you travel between foreign countries, the travel days will qualify as full days in a foreign country, provided that the time spent outside of either foreign country during the journey (i.e., time spent over international waters and/or time spent in the United States) is less than 24 hours.

The Foreign Earned Income Exclusion

If you qualify, you may elect to exclude a maximum of $102,100 in foreign earned income from your U.S. taxable income in 2017. The amount of the exclusion is indexed annually for inflation.

The amount of earned income you may exclude depends on either (1) the number of days during the year in which you were a bona fide resident of a foreign country or (2) the number of days you were physically present in a foreign country during a 12-month period. These are known as your “qualifying days.” If you are out of the United States for the entire year, you may exclude all of your earned income up to the $102,100 limit. However, if you are out of the United States for only part of the year, you generally must prorate the exclusion based on your number of qualifying days during the taxable year.

Example. You were a bona fide resident of a foreign country for 300 days during 2017. The maximum amount of income you may exclude from U.S. taxes is 300/365 × $102,100, or $83,918. Your exclusion is, of course, limited by the amount of foreign income you earn. If you earn less than the maximum allowed, you may exclude only that lower amount.

Only foreign earned income is eligible for the exclusion. Earned income is income you receive for the performance of personal services. It does not include dividends, interest, capital gains, rental property income, and other kinds of unearned income. For example, interest paid on a bank account in the United Kingdom to a U.S. expatriate on assignment in London is not eligible for the exclusion, since it is not foreign earned income.

Earned income may be received in cash or as benefits-in-kind and includes the following:

Salaries, wages, bonuses, commissions, overseas incentive premiums, and so on.
A housing allowance. This may take the form of a cash payment to you, a cash payment by your employer directly to a landlord, or housing provided by your employer. When a cash payment is made, you must report the full amount as income. When housing is provided, your employer should furnish you with an estimate of its fair market value, which is used for income-reporting purposes.
An automobile allowance. A cash allowance for an automobile should be included in your income. When an automobile is provided by your employer, an amount representing the value of its personal use to you should be included in your income.
A cost-of-living allowance.
An education allowance (e.g., for the cost of schooling your children).
Home leave. The value of home leave benefits provided to you and your family is included in your income. However, if you spend a significant portion of your home leave on business, you may be justified in characterizing your portion of the trip as a business trip and thereby exclude your travel expenses from income.
Rest and relaxation airfare.
A moving expense reimbursement or allowance, in certain cases.
A tax reimbursement or allowance.

Source of earned income. The source of earned income depends on the place where the services are rendered. If the services are performed in the United States, the income is considered U.S. source income. On the other hand, if the services are performed in a foreign country, the income is foreign source. For the income to be excluded on your tax return, the earned income must be from sources within a foreign country (or countries) and relate to services rendered in the current year.

How to compute your foreign source income. To compute your foreign source income for purposes of the foreign earned income exclusion, you must determine your earned income from sources outside the United States.

Foreign source earned income includes all income received for personal services performed outside the United States. The place of payment is irrelevant: a payment made into a U.S. bank account by a U.S.-based employer for services performed outside the United States is foreign source income. If you perform services both inside and outside the United States during the tax year, you must determine what portion of your income is from U.S. sources and what portion is from foreign sources.

Example 1. You received $50,000 for services performed in 2017. You worked a total of 240 days during the year, 235 days in the United Kingdom on foreign assignment and 5 days in the United States for a technical meeting. The source of your earned income is as follows:

Your U.S. source income is $1,042, and your foreign source income is $48,958.

There are several other considerations to keep in mind when you are figuring out the source of your income:

If there has been a significant change in your rate of compensation during the year, it may be appropriate to allocate your compensation separately for the days worked and income earned in the respective periods.
Certain fringe benefits paid by your employer are sourced on a geographical basis. The source of benefits for housing, education for your children, local transportation, and hazardous or hardship pay is the location of your principal place of work. If you are working overseas, those benefits will be foreign source earned income. If your employer pays your foreign tax, either directly or by a reimbursement to you, the amount of the payment is income to you, and it is considered foreign earned income. However, remember that only current-year foreign earned income can be excluded (with one exception noted below). For example, if your employer pays your 2017 foreign tax withholding during 2017, that payment is 2017 foreign earned income. On the other hand, if in 2017 your employer pays the balance due from your 2016 foreign tax return, it is treated as 2016 foreign earned income and is not eligible for the 2017 foreign earned income exclusion, even though the payment is income to you in 2017. The source of moving expenses paid by your employer will usually be the location of your new place of work. For more information about determining the source of income, see Publication 514, Foreign Tax Credit for Individuals.
If a payment is received during the year for services performed in a prior year, it may be appropriate to compute the foreign source portion of that payment based on the days worked in the prior year. It is not possible to exclude this prior year foreign source income using the current year’s foreign earned income exclusion, but it might be possible to exclude some or all of the income on your current year’s tax return to the extent that last year’s exclusion was not fully used up.
Do not take into account vacation or holiday travel to the United States as part of your workday calculation.

Example 2. In 2016, you were eligible for the full $101,300 foreign earned income exclusion but only had $91,300 of foreign source earned income that was excluded on your 2016 tax return. Therefore, you have $10,000 of unused exclusion from 2016. In 2017, your compensation includes $12,000 of foreign source income earned in 2016 (in this case, a bonus payment). You are able to exclude $10,000 of the $12,000 of income on your 2017 tax return. The $10,000 exclusion is in addition to any exclusion you might have for foreign compensation earned and received in 2017.

The Foreign Housing Exclusion

If you qualify as a U.S. citizen living abroad, you may elect to exclude from your U.S. taxable income the excess of eligible housing costs over a “base housing amount.” Eligible housing costs that an individual may exclude are limited to 30% of the foreign earned income exclusion ($30,630 for 2017). However, periodically the IRS issues guidance establishing higher maximum housing costs for certain geographic locations—as high as $114,300 for Hong Kong in 2017. This guidance can be found on the IRS website, www.irs.gov. The base housing amount is equal to 16% of the annual foreign earned income exclusion ($16,336 for 2017). The base housing amount is prorated by the ratio of the number of qualifying days to the total days in the year.

Example. You had $18,000 of qualified housing expenses in your 2017 qualifying period. Based on an allocation of your earned income, you determine that you had $98,000 of foreign source income. Furthermore, you had a qualifying period of 330 days in the tax year. The base housing amount is $16,336. Your housing exclusion is computed as follows:

1) Housing expenses	$18,000
2) Number of qualifying days	330
3) Total days in the tax year	365
4) Base housing amount	$16,336
5) 330/365 × $16,336	$14,770
6) Housing exclusion (line 1 − line 5)	$ 3,230

Assuming the same facts, you calculate your foreign earned income exclusion as follows:

1) Maximum foreign earned income exclusion	$102,100
2) Number of qualifying days	330
3) Total days in tax year	365
4) 330/365 × $102,100	$92,310
5) Total foreign source income	$98,000
6) Less: Housing exclusion	($3,230)
7) Total foreign source income available for exclusion	$94,770
8) Smaller of line 4 or 7	$92,310

Your foreign earned income exclusion is $92,310. In addition, your foreign housing exclusion is $3,230. Your total exclusion is $95,540.

Foreign housing deduction for self-employed individuals. If you are a self-employed individual and you do not have an employer to provide housing, you may deduct the cost of foreign housing, net of the base housing amount subject to the limitations discussed above, in computing your adjusted gross income. Your housing deduction is limited to the amount by which your foreign earned income exceeds your foreign earned income exclusion for that year.

If you are both an employee and a self-employed individual during the same tax year, see Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.

TAXPLANNER

When to elect the foreign earned income exclusion and the foreign housing exclusion. You elect and calculate the foreign earned income exclusion and the foreign housing exclusion separately using Form 2555, Foreign Earned Income, or, in some cases, Form 2555-EZ, Foreign Earned Income Exclusion. The elections can be made on a tax return that you file on time, on an amended tax return, or on a late-filed tax return that is filed within 1 year of the original due date. The IRS also allows the elections to be made later under certain circumstances. When you are deciding whether or not to use the exclusions, you should take into account a number of factors, including the level of taxation in the foreign country in which you are living, the type of foreign assignment you are on, and your employer’s policies concerning individuals on foreign assignment.

When you elect the foreign earned income exclusion, you are required to reduce your otherwise deductible expenses that are associated with the excluded income. Similarly, foreign taxes available for the foreign tax credit must also be reduced (see Foreign Tax Credit, later).

If you are living in a foreign country with a high tax rate, you may be better off forgoing the exclusions and claiming a larger foreign tax credit. In this case, forgoing the exclusions might result in a higher current tax liability but may also create larger foreign tax credits that you might be able to use in other years to offset tax on foreign source income. In countries with moderate or low tax rates, it is usually to your advantage to claim the exclusions. In any event, you should calculate your taxes with and without the exclusions to see which is more beneficial to you.

Once you elect the exclusion(s), you may revoke either or both of them by attaching a statement to your return or your amended return stating that you do not wish to claim the exclusion(s). Once revoked, you may not claim the exclusions again for the next 5 years without obtaining IRS approval.

Employer-Provided Meals and Lodging

Meals and lodging provided in kind by, or on behalf of, an employer to an employee or to his or her spouse or dependents are excluded from taxable income if certain requirements are met:

The meals are provided on the business premises of, and for the convenience of, the employer.
Lodging is furnished on the premises of, and for the convenience of, the employer, and the employee is required to accept this lodging as a condition of employment.

The IRS has taken a narrow view of the lodging exclusion. As a result, most employer-provided lodging is not excludable from your income. However, the exclusion applies if the employee resides in a camp that is provided by the employer because the employee’s work site is in a remote area where satisfactory housing is not available on the open market. The camp has to be located as near as is practicable to the work site and should be furnished with a common area or enclave that is not available to the general public and normally accommodates 10 or more employees.

Foreign Tax Credit

You may elect to claim a credit for foreign income taxes paid or accrued during the tax year, or you may claim the taxes paid as an itemized deduction. Generally, claiming a credit is more beneficial, since it results in a dollar-for-dollar reduction in your tax bill. The foreign tax credit on your U.S. return is limited to the lesser of (1) the actual foreign income taxes paid or accrued during the year (including carrybacks or carryforwards) or (2) the amount of U.S. tax attributable to foreign source taxable income for the year. The foreign tax credit is elected and calculated on Form 1116, Foreign Tax Credit (see chapter 38, Other credits including the earned income credit).

As mentioned above, if you elect either the foreign earned income exclusion or the foreign housing exclusion, the amount of foreign taxes that is available for credit is reduced.

Example 1. You had $98,000 of foreign source income and $18,000 of qualified housing expenses in 2017. The total amount you may exclude from your income is $95,540. (See the preceding foreign housing exclusion example to learn how this number is calculated.) You paid $5,000 in foreign taxes for the year. You figure the amount that you must reduce foreign taxes available for foreign tax credit as follows:

Consequently, a maximum of $126 ($5,000 − $4,874) may be claimed as a foreign tax credit.

Example 2. You are an unmarried U.S. citizen currently residing in the United Kingdom. Your total gross income for the year is $140,000, all of which is compensation. You qualify for a foreign earned income exclusion of $102,100 and a housing exclusion of $2,500, for a total of $104,600. You spent 10% of your working days in the United States. You have $7,000 of itemized deductions, none of which directly relate to a particular class or source of income.

The amount you may claim as a foreign tax credit is computed as follows:

Compensation from foreign sources (90% of $140,000)	$126,000
Deductions allocated to foreign source compensation: ($7,000 × 90%)	($6,300)
Less: Foreign earned income and housing exclusions	($104,600)
Foreign source taxable income	$15,100
U.S. source compensation (10% of $140,000)	$14,000
Balance of itemized deductions ($7,000 minus $6,300)	($700)
Total taxable income before personal exemptions	$28,400

The foreign tax credit limitation is calculated by determining the ratio of foreign source taxable income to total taxable income (as shown above). The ratio in the above example would be

This ratio is then multiplied by the U.S. tax liability for the year to determine the maximum amount of foreign tax credit usable for the year. If we assume that the U.S. tax is $6,818, the maximum credit would be $3,627 (0.532 × $6,818).

Carryback and carryforward of foreign tax credit. Example 1 (above) shows how to determine the amount of foreign taxes that may be used as a credit. Example 2 (above) shows how to determine the maximum amount of foreign tax credit that may be currently used as a credit against your U.S. taxes. If the amount of the creditable foreign taxes paid or accrued in the current year exceeds the amount that may be used currently, you may carry back the excess 1 year. The remainder, if any, may be carried forward for up to 10 years. The excess credit must be carried back first, and used in the preceding year if possible, before it can be carried forward.

TAXPLANNER

Planning tips for individuals on international assignment. Here is a list of items you should consider in planning your tax affairs and preparing your tax return:

Sale of your principal residence. A taxpayer may claim an exclusion of up to $250,000 for single taxpayers ($500,000 for joint filers) once every 2 years if the taxpayer owned the residence and occupied it as a principal residence for at least 2 of the 5 years before the sale or exchange. The amount of excludable gain may be limited if the property was used as a vacation or rental property or if the property was left vacant (see chapter 15, Selling your home).

There are no special rules for U.S. home sales by expatriates. If you have a significant gain built up in your home and you expect your assignment to last more than 3 years, you should consider to selling your home. Otherwise, if you decide to sell at a later date, you may fail the 2-year out of 5-year test and some or all of the exclusion may be lost (see chapter 15, Selling your home).

Keep in mind that if you purchase your primary residence in a foreign country, the amount of any gain will be affected by changes in the foreign exchange rate. In addition, principal payments on a foreign mortgage may result in a taxable exchange gain.
Individual retirement arrangements (lRAs). An expatriate who contributes to an IRA (see chapter 17, Individual retirement arrangements [IRAs]) must have earned income in excess of the total of his or her foreign earned income and foreign housing exclusions if he or she elects to use the exclusions.

If you are covered by a company pension plan, your modified adjusted gross income must be below a certain level for your IRA contribution to be tax deductible. Similarly, your modified adjusted gross income must be below a certain level in order to make a contribution to a traditional IRA or a Roth IRA. Note that for purposes of computing modified adjusted gross income, the foreign earned income exclusion and the foreign housing exclusion amounts must be disregarded. For a more detailed discussion of IRAs, refer to chapter 17, Individual retirement arrangements (IRAs).
Report of foreign bank and financial accounts. You should become familiar with the filing requirements of FinCEN Form 114, Report of Foreign Bank and Financial Accounts, which is a form that is used to provide information concerning foreign bank and financial accounts if in the aggregate their value exceeds $10,000. Significant penalties apply for noncompliance.
Statement of specified foreign financial assets. You should also become familiar with the requirements of Form 8938, Statement of Foreign Financial Assets. This form mandates reporting the highest fair market value of each foreign financial asset during the year for U.S. citizens and tax residents if the aggregate values of these assets exceed minimum thresholds. Examples of foreign financial assets include foreign bank and brokerage accounts, ownership interest in foreign companies/partnerships, bonds issued by a non-U.S. resident, ownership interest in a foreign trust, estate, or pension, or a derivative instrument with respect to the above assets. Minimum thresholds for reporting vary based on the taxpayer’s filing status and residence abroad. Significant penalties apply for noncompliance. Although some reportable information will be identical to Form 114 (described above), Form 8938 represents a separate additional reporting obligation to the U.S. taxpayer. Further information can be found on the IRS website, www.irs.gov.

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Table of Contents for Chapter 42: U.S. citizens working abroad: Tax treatment of foreign earned income

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Table of Contents for
Chapter 42: U.S. citizens working abroad: Tax treatment of foreign earned income