As work fields broaden, more people work abroad earning income in foreign countries. Americans working outside their native countries are subject to Foreign Earned Income Exclusion (FEIE), Foreign Tax Credit, and Foreign Housing Exclusion on their US tax returns. These tax deductions can help save someone a small fortune. However, like other deductions and tax regulations, there are guidelines in order to qualify. It is essential to understand the rules to take advantage of these deductions. It is also important to consult a tax professional to ensure accuracy in filing.
Foreign Earned Income Exclusion
The most utilized exemption is the Foreign Earned Income Exclusion. This exclusion benefits Americans with foreign-earned income that maxes out at $120,000 per individual for the 2023 tax year. Each year, the exclusion amount is adjusted for inflation (2020’s exclusion was $107,600). Since taxes are still applied to foreign income in the foreign country at the country’s tax rate, FEIE prevents Americans from having to pay taxes twice on their income by exempting it from US taxes. However, once a tax filer claims Foreign Earned Income Exclusion, they must utilize this every year that they have foreign income until it is formally revoked. Once it is revoked, it cannot be utilized for another five years unless permission is received from the IRS under a special ruling that costs $2,000.
Only foreign-earned income is allotted for FEIE. Earned income is identified as wages, salaries, commissions, bonuses, and tips earned from working. Passive income, such as dividends and capital gains, are not permitted for exclusion. The income must also be accumulated on foreign grounds. For example, a US company paying wages on foreign soil is included, but a foreign company paying wages on US soil is not. Moreover, income from the United States Government, payments made in international waters or airways, and anything received after the end of the tax year are not exempt.
There are two tests that enable someone to be qualified for FEIE that account for the residency and presence of Americans working abroad. Deciding which test to determine your status is pivotal in your eligibility for FEIE.
- Physical Presence Test
This test considers three aspects: the earning of foreign income, a tax home (being engaged in work) in a foreign country, and physical presence in the foreign country for at least 330 days of a 12-month period.
- Bona Fide Residence Test
To pass the Bona Fide Residence Test, someone must have foreign-earned income, a tax home in a foreign country, and be a bona fide resident for a full tax year. An individual who is a bona fide resident lives abroad, does not intend to return to the US, and has more connections to that country than to the US.
To pass either test, proof must be obtained. Without proof, the test is invalid. This is why documenting your travels is essential to show that you have been living abroad. This includes records of where you stayed, the duration of the stay, what you did, and how you supported yourself. Additionally, it is important to keep records of your passport, visa, and other immigration documents. With both tests, there are two exceptions that change the regulations: war/unrest and travel restrictions.
Filing for Foreign Earned Income Exclusion is completed by filing Form 2555. This form is completed by each individual living abroad regardless of filing status. To file for exclusion, individuals must indicate which test is used, dates of travel, Form 2555 from the prior year if available, and documentation of the earned income. If residency outside of the US is not long enough to claim FEIE, Form 2350 may be filed to extend the tax filing deadline. Once the deadline to file is extended, the time qualification for FEIE can be obtained. Tax filers must declare FEIE status within one year of the tax due date. However, if the taxes haven’t been filed yet, the IRS hasn’t realized the failure to file, or if there are no taxes due with the exclusion, then claiming the exclusion is still possible after the one-year mark.
Foreign Tax Credit
The Foreign Tax Credit is another option to provide relief to Americans working abroad. This credit allows people to reduce their US taxes based on the taxes they have paid to foreign governments. For example, if $4,000 in taxes have been paid to a foreign country, then a $4,000 credit is available for the US tax return. Similar to the Foreign Earned Income Exclusion, there is a cap on how much can be claimed and there are qualifying factors to be eligible. Someone can claim both FEIE and the Foreign Tax Credit, but it must be for separate incomes. Based on an individual’s circumstances, foreign earned income exclusion or foreign tax credit should be chosen accordingly because choosing incorrectly could cost you thousands of dollars.
Foreign Housing Exclusion
Tax filers can also claim the Foreign Housing Exclusion on their US tax return if the housing costs exceed 16% of the year’s FEIE, but it is not able to surpass 30% of the foreign earned income or $36,000 for 2023. This enables a US tax reduction based on housing costs accumulated in foreign countries. A portion of rent, utilities, insurance, property tax, and furniture rentals can be included. The amount that is eligible for deduction is dependent on the location of residency. To take advantage of this deduction, the foreign housing expenses must be itemized on a separate tax return and the expenses must be allocated between personal and business use.
Oversights
With the numerous mandates for foreign-earned income, it is easy to overlook things. Many people believe that if the income is excluded from US taxes, a US tax return does not need to be filed, however, filing is still a necessity. On the other hand, issues also occur when tax filers assume that FEIE, Foreign Housing Exclusion, or the Foreign Tax Credit is automatically applied to the US tax return. Additionally, problems arise when exclusions are not calculated correctly. For example, FEIE must be computed based on the time spent in the country, so moving abroad mid-year only qualifies for a percentage of FEIE, not the whole exclusion. Different rulings apply to different situations, so it’s imperative to understand how to maximize your foreign income.
Choosing Benefits
Choosing the right tax benefit can be daunting. Each foreign income exclusion and credit has multiple regulations and qualifications, and every situation is unique and requires special attention. This is why contacting your certified accountant is the best way to know whether you meet the necessary conditions to claim the tax credits and/or exclusions and which decision is best for you. Contact Kislay Shah CPA to discuss your financial situation to maximize the benefits available to you. You can contact Shah at kislay@shahcpaus.com or call 646-328-1326.