Foreign Earned Income Exclusion

Simon Misiewicz

Simon Misiewicz

Expat & Property Tax Specialist

9th May 2022

Foreign earned income

The foreign earned income exclusion and foreign housing exclusion are for Americans to reduce their 1040 taxable income payable to the IRS for earned income in the United Kingdom.

It is essential to understand how to accurately complete a foreign earned income exclusion form (Form 2555/Form2555-EZ) and establish if you can claim for foreign earned income tax exclusion.

What are the basics of foreign earned income?

It is important to understand the definition of foreign earned income and how much is foreign earned income.

Americans can also benefit from foreign earned income housing exclusion.

Foreign earned income includes wages, salaries, professional fees or other amounts paid for personal services rendered.

The IRS considers income foreign if payments are made outside the US. A clear indication of the location of the activity is necessary on all supporting documentation.

US citizens must pay tax to the IRS on foreign income if they meet the filing thresholds, usually equivalent to the standard deduction for your filing status.

US citizens pay taxes on income earned abroad because IRS taxes are based on citizenship, not the country of residence.

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What is the Foreign Earned Income Exclusion?

The Foreign Earned Income Exclusion (FEIE) is an IRS exemption that American ex-pats can claim when they file their US tax return from abroad to reduce (and in some cases eliminate) their US tax bill.

It allows ex-pats to exempt the first $100,000 of their earned income from US taxation.

The exact threshold rises annually based on inflation.

The FEIE can only be used to exclude certain types of income.

To find out more about qualifying for foreign earned income exclusion, read these IRS guidelines.

Some ex-pats may be able to use a shorter and simpler version of Form 2555 called Form 2555-EZ.

To qualify for using Form 2555-EZ, ex-pats must meet the following criteria:

– They are not also claiming the Foreign Housing Exclusion or Deduction

– The period they are claiming for is a calendar year

– They have no self-employed income

– They do not earn more than the threshold for that year

– They have no business or moving expenses for that year

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How do I qualify for the Foreign Earned Income Exclusion?

To claim the Foreign Earned Income Exclusion, ex-pats must demonstrate that their tax home is abroad by meeting one of two IRS definitions.

The first of these two tests is called the Physical Presence Test.

The Physical Presence Test requires ex-pats to prove they were physically present for at least 330 full days outside the US in a 12-month period that coincides with the tax year.

The second of the two IRS tax home tests is the Bona Fide Residence Test.

The Bona Fida Residence Test requires ex-pats to prove that they are a permanent resident in a foreign country.

This might be by having a permanent residency visa, paying foreign income taxes based on their country of residence, or through proof of housing rental and utility bills in their name.

The Physical Presence Test is helpful for ex-pats who are moving between countries or who cannot demonstrate permanent residence in any one foreign country.

It does require ex-pats to limit the number of days they spend in the US to ensure they spend at least 330 full days abroad.

The Bona Fide Residence Test is useful for ex-pats who can demonstrate their tax home is in another country, and they do not want limits placed on the number of days they spend in the US each year.

The Foreign Earned Income Exclusion can only exclude some income types rather than all income from US taxation. It can only be used to exclude earned income.

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What does the IRS classify as Earned Income?

Earned income includes salary, wages, commissions, bonuses, self-employment income and professional fees, and the value of any other compensation for services.

It doesn’t matter where in the world the payment is made or received as long as the income qualifies and the ex-pat can prove they lived abroad when they earned it.

Unearned income cannot be excluded. This includes social security benefits, pension income, rental income, dividend income, interest, gambling winnings, capital gains, annuities and alimony payments.

Foreign earned income does not include amounts for personal services provided to a corporation that represent a distribution of earnings and profits rather than reasonable compensation.

Further examples of income types that can’t be excluded by ex-pats claiming the Foreign Earned Income Exclusion are:

– Payments received as a military or civilian employee of the US Government

– Payments received for services conducted in international waters

– Payments received after the end of the tax year or other 365-day period

– Meals and lodgings that are excluded from income for an employer’s convenience

The Foreign Earned Income Exclusion is not a solution for all ex-pats to avoid paying US taxes.

It depends on their circumstances, including their income types and levels and their foreign residency and travel arrangements.

Need to apply for an ITIN?

Our Certified Acceptance Agents can help you obtain an ITIN. We will need to meet face to face at our Nottingham office or your place of work/home

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What is the Foreign Housing Exclusion?

The Foreign Housing Exclusion reduces an ex-pat’s tax liability by allowing certain housing expenses to be deducted from taxable income.

The IRS created it to offset the expenses that go in line with living overseas.

Ex-pats who claim the Foreign Income Exclusion and earn over the income threshold of $108,700 whilst renting a home abroad benefit from another tax credit called  Foreign Housing Exclusion.

The Foreign Housing Exclusion allows ex-pats employed abroad and who earn over the FEIE limit to exclude a further amount of their income from US taxation based on a proportion of their housing expenses.

Qualifying housing expenses include rent payments, utility bills, fees for securing a leasehold, residential parking costs, occupancy taxes, property insurance, furniture rental and necessary repairs.

Mortgage payments, purchased furniture and domestic help costs do not qualify.

Ex-pats can claim the Foreign Housing Exclusion by using Form 2555.

Free Online Tax Courses

Want to save tax in the future?

We have now created free online tac courses to help you build wealth whilst paying less tax. Learn today and save tax tomorrow. We have covered the basics of tax filing with HMRC and IRS. We have created courses on advanced planning strategies that will save you tax in the future.

We have training programmes for UK tax and US tax. Learn today and save tax tomorrow

Free online tax course

Free – Access NOW!!

How do I report foreign income to the IRS?

You must attach Form 2555 to your Form 1040 or Form 1040X to claim the foreign earned income exclusion, the foreign housing exclusion or the foreign housing deduction.

Do not submit Form 2555 by itself.

A qualifying individual may claim the Foreign Earned Income Exclusion on foreign earned self-employment income.

The excluded amount will reduce your regular income tax, not your self-employment tax.

Also, as a self-employed individual, you may be eligible to claim the Foreign Housing Deduction instead of a Foreign Housing Exclusion.

It is also advisable to understand the UK and US tax treaties rules before reporting income to the IRS.

US & UK Tax return Services

Fed up using an American CPA or EA in one firm to file your 1040 tax return and a UK based accountant to file your UK tax return?

Optimise accountants hires both UK qualified tax accountants and US qualified tax accountants under the same roof to help you streamline your international expat tax affairs.

Learn more about our services

Who should claim the Foreign Earned Income Exclusion?

The Foreign Earned Income Exclusion is a legal way for ex-pats to reduce their US tax bill, although they still have to continue filing a US tax return each year reporting their worldwide income.

Ex-pats who earn less than the annual FEIE threshold, whose only income is earned, who either don’t pay foreign income tax or who pay foreign income tax at a lower rate than the US rate, and who can prove that they live abroad according to IRS criteria often benefit from claiming the FEIE.

The FEIE may be used by:

– Ex-pats with unearned income

– Those who earn over the annual FEIE threshold

– Anyone who pays foreign income taxes at a higher rate than the US rate

– Those who are unable to prove that they live abroad. They may need to explore other options to avoid paying US taxes abroad.

Ex-pats whose income is paid in a foreign country and who pay foreign income taxes may be better off claiming the US Foreign Tax Credit, which they can claim to offset their US income tax bill based on the value of the foreign tax they have already paid.

Ex-pats can claim the US Foreign Tax Credit by filing Form 1116 as part of the 1040 federal return.

If they pay foreign tax at a higher rate than the US rate, they will eradicate their US income tax liability and give them excess US tax credits that they can carry forward for up to 10 years.

Other advantages of claiming the Foreign Tax Credit rather than the Foreign Earned Income Exclusion for ex-pats are that there is no IRS limit set on the number of tax credits that can be claimed.

It also doesn’t matter whether the income is earned or unearned, as long as foreign income tax is paid.

Ex-pats can claim the Foreign Tax Credit and the Foreign Earned Income Exclusion but not on the same income.

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