Foreign Earned Income Exclusion (FEIE), allows the individuals earning abroad to only be taxed in the country where income is earned, provided he/she meets the requirements. The guide explains how to avail of FEIE and save your money from Uncle Sam.
Foreign income refers to the wages, salaries or fees received by services performed in a foreign country. There are three types of income classified as earned, unearned and variable. Unearned income stems from sources such as stocks, dividends, capital gains, etc, whereas variable income can belong to either earned or unearned income, which includes income sources such as royalties or profits from business. So foreign earned for example is, if you receive wages for services performed in Germany, even if it was deposited into your US bank account. Additionally, any reimbursements received is also classified as earned income.
For US expats and American Indians, the income earned abroad can be tax free or limited provided the requirements are met. When availing of FEIE, the individual can also opt for Foreign Housing Exclusion.
To qualify for Foreign Earned Income Exclusion, the U.S. taxpayer must first file his/her tax return, as it is not automatically applied to the income earned abroad. Secondly, he/she must pass the residency or physical presence test and finally the income earned must qualify under the allowable sources of income.
Unless you have declared to the foreign country that you are not a resident of the country, if your stay in the foreign country lasts one full calendar year, for example January 1st to December 31st, then you can avail of FEIE. To avoid double taxation the individual would be subject to foreign tax laws, but can avoid paying/minimizing taxes in their home country (the U.S.A) by availing of FEIE. The taxpayer is also allowed to make short visits to the U.S. or other countries, provided they are planning on returning to the foreign country.
To qualify under the physical presence test, the individual must have been a resident in the foreign country for 330 full days in an uninterrupted 12-month period. This rule is more relaxed as you can work and be living in several countries. A full day means 24 hours; therefore the date of arrival and departure are usually not counted. Additionally, both working days and days spent on vacation in the foreign country can be counted in the physical presence test.
All income earned as salary or as self-employed or contractor can be used when applying for FEIE. This means income earned on capital gains, shares etc. are not included. However, foreign tax credit can be applied on capital gains. Moreover, pension income or rental income cannot be included.
The tax applicable on the income is first calculated on the whole amount before the application of FEIE. Then the taxable amount on Foreign Earned Income Exclusion is calculated, after which the difference will be paid.
|Income Earned||Taxes Due|
The worksheet for determining amount of taxes due after applying FEIE, can be made by using the 1040 worksheet, found here.
|Taxation Year||FEIE Amount (U.S Dollars)|
The following types of income cannot be included when availing of Foreign Earned Income Exclusion.
After availing of the foreign earned income exclusion, to further reduce your tax liability, the housing exclusion can be applied on the remainder amount. The amount of housing exclusion applicable is determined by the housing deduction provided by the employer. To calculate the foreign housing exclusion, IRS form 2555 can be used. The limit on housing expenses varies depending upon the location in which you incur housing expenses. The following is a list of some of the things that can be used to qualify for housing deduction, based on the provisions of the employer:
The basic formula used for calculating foreign housing deduction is:
Housing expense limitation – Base housing cost (as per line 32 of form 2555) = Maximum housing exclusion.
Hari is eligible for a maximum foreign housing deduction of $75,000 and the limit amount is set to $57,000 with a base cost of $15,870, then his actual maximum housing exclusion limit that he can avail of is $41,130.
To determine and claim your foreign earned income exclusion and/or your foreign housing exclusion, IRS form 2555 is used, which must be filed with your annual tax return. The instructions for form 2555 can help in calculating your yearly exclusion amounts, including housing deduction. Additionally, once you choose to adopt an exclusion, your choice to claim it remains in effect until you decide to cancel it.
Using Foreign Tax Credit (FTC) with FEIE combined is only advisable if the tax rate of the foreign country is lesser than that of the U.S. Using FTC on the remaining FEIE amount, reduces the tax liability in the US. Additionally, the credit cannot exceed the amount of U.S. taxes owed.
For individuals who are self-employed, including freelancers and those on contract, in a foreign country, he/she must decipher their total foreign Earned Income with the allowable exemptions. Since, with salaried employees, housing deductions are given by the employer, the self-employed individual must consider the amount of housing deduction, which is calculated by determining the business income earned correctly. To determine how to maximize the exemptions allowed for self-employed, the aid of third party tax advisors can be availed. However, for both self-employed and salaried individuals FEIE can only be applied if U.S. tax return is filed.
One of the most important lessons learned on the path to self-improvement is knowing when to ask for help. Availing of the various provisions allowed for taxpayers can be tricky and complicated and even more so for individuals with foreign income. To ensure you maximize on your tax deductions, enlist the aid of the U.S. Expat tax experts at H&R Block India.