Article Highlights:
- Qualifications
- Tax Home in a Foreign Country
- Foreign Earned Income
- Bona Fide Residence Test
- Physical Presence Test
- Foreign Housing Exclusion and Deduction
- Married Couples
- Self-Employed Individuals
- Earned Income Tax Credit
- Foreign Tax Credit
- Combat Zone Workers
- Flight Attendants
- State Tax
A part of foreign earned income can be exempt from U.S. taxation for both U.S. citizens and resident aliens who live overseas thanks to the Foreign Earned Income Exclusion (FEIE) under Section 911 of the Internal Revenue Code. This exclusion level is $126,500 (yearly inflation adjusted) per individual for the tax year 2024. With regard to income taxed by both the United States and the foreign nation where it is earned, this clause attempts to reduce the potential double taxation burden. Three main requirements must be satisfied for an individual to be eligible for the FEIE.
Qualifications - To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must:
- Have foreign earned income (income received for working in a foreign country, including payroll disbursements from a U.S. employer and self-employment income),
- Have a tax home in a foreign country, and
- Meet either the bona fide residence test or the physical presence test.
Tax Home in a Foreign Country: The individual's tax home must be in a foreign country. A tax home is defined as the general area of an individual's primary place of business or employment, regardless of the family home location. This criterion ensures that the individual is genuinely working and earning income abroad.
Foreign Earned Income: The income must be earned for services performed outside the U.S. This includes wages, salaries, professional fees, and other compensation for personal services rendered.
Bona Fide Residence or Physical Presence Test: The individual must either be a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year or meet the physical presence test by being physically present in a foreign country for at least 330 full days during a 12-month period.
- Bona Fide Residence Test - The bona fide residence test requires an individual to demonstrate that they have established a genuine residence in a foreign country for an uninterrupted period that includes an entire tax year. Factors considered include the individual's intention, purpose of the trip, and nature and length of the stay abroad. Temporary absences from the foreign country for vacations or brief trips to the United States for business or personal reasons do not necessarily disqualify an individual from being considered a bona fide resident.
- Physical Presence Test - The physical presence test is more straightforward, requiring the individual to be physically present in a foreign country or countries for at least 330 full days within a consecutive 12-month period. These days do not need to be consecutive, but they must fall within a single 12-month window. This test allows for greater flexibility, as it does not consider the individual's intentions or reasons for being in the foreign country. When the period for which the individual qualifies for the FEIE includes only part of the year, the exclusion limit must be adjusted based on the number of qualifying days in the year.
Foreign Housing Exclusion and Deduction - In addition to the FEIE, U.S. citizens and resident aliens working abroad may also qualify for the foreign housing exclusion or deduction. This provision allows for the exclusion or deduction of certain amounts paid or incurred for household expenses that occur because of living abroad. Qualifying expenses include rent, utilities (excluding telephone charges), real and personal property insurance, residential parking, and certain occupancy taxes. The amount of the foreign housing exclusion or deduction is subject to limitations based on geographic location and is calculated based on housing expenses that exceed a base amount.
The housing exclusion is limited to 30% of the taxpayer's earned income exclusion for the year less the base amount. Thus, for 2024, the maximum housing allowance exclusion is $17,710 (($126,500 x .30) - $126,500 x .16)).
- Higher Caps for High-Cost Locations - The Code allows the 30% cap amount to be replaced by higher amounts based on geographic differences in housing costs relative to housing costs in the U.S. The IRS annually identifies locations within countries with high housing costs and provides an adjusted limitation on housing expenses to be used for these localities for the tax year.
Special Situations
- Foreign Earned Income - Does Not Include:
- Pay received as a military or civilian employee of the U.S. Government or any of its agencies.
- Pay for services conducted in international waters (considered not to be a foreign country).
- Pay in specific combat zones, as designated by a Presidential Executive Order, that is excludable from income.
- Payments received after the end of the tax year when the services were performed to earn the income.
- The value of meals and lodging that are excluded from income because they were furnished for the employer's convenience.
- Pension or annuity payments, including Social Security benefits.
- Married Couples - Both spouses may claim the FEIE up the maximum amount for the year provided they each individually meet the qualifications. Thus, for example, a married couple both with foreign earned income can exclude up to $126,500 each, which if they both qualify for the annual maximum, means they could exclude up to $253,000 for 2024. However, if one spouse's foreign earned income exclusion is less than the maximum amount, the excess cannot be transferred to the other spouse.
- Married Couples Living Apart - Special rules apply if taxpayer and spouse live apart and maintain separate households. Both may be able to claim the foreign housing exclusion or the foreign housing deduction. This can be done if the spouses have different tax homes that are not within reasonable commuting distance of each other. Otherwise, one spouse only can exclude or deduct a housing amount.
- Self -Employed Individuals - A qualifying individual may also claim the foreign earned income exclusion on foreign-earned self-employment income. The excluded amount will reduce the individual's regular income tax but will not reduce his or her self-employment tax. Also, the foreign housing deduction-instead of a foreign housing exclusion-may be claimed.
- Earned Income Tax Credit - Once the foreign earned income exclusion is claimed, the earned income credit cannot be claimed for that year.
- Foreign Tax Credi t - Where an individual is required to pay taxes to the foreign country where they are working, they have the option of claiming a foreign tax credit or claiming the FEIE for the same income. If the FEIE is chosen, a foreign tax credit can still be claimed for income more than the excluded amount and other income subject to foreign taxes.
- Combat Zone Workers -Certain U.S. citizens or resident aliens, specifically contractors or employees of contractors supporting the U.S. Armed Forces in designated combat zones, may qualify for the foreign earned income exclusion even if their "abode" is in the United States.
- Flight Attendants - International flight attendants can qualify for the foreign earned income exclusion, but there are limitations. According to a tax court case involving an international flight attendant based out of Hong Kong International Airport, the Tax Court ruled that wages she earned while working in international airspace did not qualify as foreign earned income eligible for exclusion. Additionally, the flight attendant was required to include pre-flight and post-flight service time and allocate sick, and vacation leave between excludible and non-excludible portions of her flight attendant's income.
- Ship Crew Members- The IRS specifies that for the FEIE, a foreign country is any territory under the sovereignty of a government other than that of the United States. Time spent in international waters does not count towards the Physical Presence Test, and by extension, work performed in international waters does not directly contribute to foreign earned income. However, income earned while the ship is docked in foreign ports may qualify.
- State Tax - If the U.S. state of residence when departing the U.S. is one with state income tax, there may be a requirement to report all the foreign income on the state tax return, unless there is an exception.
If you are considering foreign employment or traveling abroad while working, before you make your final decision, please contact our office to learn more about the foreign earned income and housing allowance exclusions, or about how to meet the bona fide residence or physical presence tests.
