February 03, 2011
What You Should Know About Excluding Income Earned Overseas
By Jennifer Brittelli, Supervisor, Tax & Business
The foreign earned income exclusion applies only to people working overseas and to those companies who send workers overseas. For those who do work abroad, or did so within the last few years or plan on doing so in the future, here are some tips that you should keep in mind to claim the foreign earned income exclusion.
Benefits are Limited to U.S. Citizens and Resident Aliens
You will not qualify to take the foreign earned income exclusion if you are not a U.S. citizen or a resident alien. You must file a U.S. tax return and report your worldwide income. If you are living and working abroad you may be entitled to a foreign earned income exclusion and a housing exclusion or deduction. In 2010, you can exclude up to $91,500 from your U.S. income. To claim the exclusion you will need to fill out Form 2555 and attach it to your Form 1040.
You Must Meet Three Basic Rules
First, your tax home must be in a foreign country. Second, you must have foreign earned income. Third, you must also fall into one of the following two categories: a U.S. citizen who is a bona fide resident of a foreign country for an uninterrupted period of at least one year (the “bona fide resident test”), or a U.S. citizen or a U.S. resident alien who is physically present in a foreign country for at least 330 days during any 12 consecutive months (the “physical presence test”).
The Income Must Be Earned
Only earned income qualifies for the foreign earned income exclusion. Earned income means salary, wages, commissions, bonuses, professional fees, and other amounts received as compensation for services rendered (e.g., cost-of-living allowances and moving expense reimbursements). You must earn the income from services that you actually perform overseas.
You Forgo the Foreign Tax Credit
If you claim the foreign earned income exclusion, you cannot claim a foreign tax credit on the same income even if you paid foreign taxes on such income. Here are some tips on how to figure out which one may be more beneficial to you:
- If you pay no foreign tax, claim the foreign earned income exclusion.
- If your foreign tax rate is lower than your U.S. rate, you should most likely claim the exclusion.
- If your foreign tax rate is higher than your U.S. rate, you should probably claim the foreign tax credit.
Foreign Tax Home Requirement
You must have a “tax home” in a foreign country throughout your period or residence (under bona fide residence test) or physical presence (under the physical presence test). Your tax home is your regular or principal place of business, employment, or post of duty, regardless of where you maintain your family home. If you do not have a regular or principal place of business, your tax home is your regular place of abode, which is your home, residence, domicile or place of dwelling. If your abode is in the United States, you cannot have a tax home in a foreign country.
Your Assignment Cannot be Temporary
The location of your tax home depends on whether your assignment is temporary or indefinite. If you are only temporarily assigned to work overseas, your tax home in the U.S. is maintained and you cannot claim the foreign earned income exclusion. However, if your foreign work assignment is indefinite, in that you expect your employment abroad to last for more than a year, your new place of work becomes your tax home, which allows you to qualify to claim the foreign earned income exclusion.
You Might Still Qualify Based on Physical Presence
Even if you are not a bona fide resident of a foreign country, you can still qualify for the exclusion if you meet the physical presence test. To meet the physical presence test, you must be physically present in a foreign country for 330 full days during 12 consecutive months. The 330 days do not have to be consecutive. A full day is a continuous period of 24 hours commencing at midnight. When you leave the United States to go directly to a foreign country or when you return directly to the United States from a foreign country, the time you spend over international waters does not count toward your 330 day total.
You Might Be Entitled To Housing Costs Too
If you qualify for the foreign earned income exclusion, you may also qualify to exclude from income certain housing costs paid or reimbursed by your employer. Alternatively, if you are self-employed, you can deduct eligible housing costs. Your housing cost exclusion (or deduction) is generally your total foreign housing expenses in excess of a base housing amount, subject to certain limitations. The base housing amount is 16% of the $91,500 foreign earned income exclusion, multiplied by the number of qualifying days overseas. You must reduce your housing amount by any U.S. government allowance you received to compensate you for housing expenses.
What Qualifies as Housing Expenses
These are expenses that are reasonable for housing in a foreign country for you, your spouse, and dependents that live with you. You can only count housing expenses for the part of the year that you qualify for the foreign earned income exclusion, and only up to a limit generally equal to 30% of the maximum foreign earned income exclusion. For 2010, the maximum housing cost exclusion (or deduction) is generally $27,450, but may be higher depending on the location of your foreign tax home.
Housing expenses include:
- The fair rental value of housing provided in kind by your employer
- Utilities (but not telephone charges)
- Nondeductible occupancy taxes
- Nonrefundable fees to secure a leasehold
- Furniture rental
- Residential parking
Housing expenses do not include:
- Lavish or extravagant expenses
- Deductible interest and taxes
- Costs of buying furniture or other property, including principal payments on a mortgage
If you work abroad, you should understand the basic procedures and calculations for qualifying and determining the foreign earned income exclusion and if it would be beneficial to you.