Qualifying U.S. taxpayers with a tax home outside the United States are entitled to elect two exclusions to reduce their U.S. taxable income: the foreign earned income and the foreign housing cost exclusions. The exclusions are available only if the taxpayer maintains a foreign tax home and meets either the bona fide residence or physical presence test requirements.
Foreign Earned Income Exclusion
Is allowed in full only if the taxpayer remains qualified during the entire tax year. Otherwise, the exclusion is reduced proportionately for the number of days during the tax year that the taxpayer does not qualify for the exclusion. The full, annual exclusion is capped at $102,100 for calendar year 2017.
Married taxpayers may each claim the foreign earned income exclusion, but each must qualify separately. If one spouse has any unused exclusion, the other spouse may not use it. If married taxpayers reside in a community property state/country, community property law is generally disregarded in determining the amount of foreign earned income attributable to each spouse.
Foreign Housing Exclusion
Qualifying taxpayers may make an additional election to exclude from their gross income an amount equal to certain housing costs, as long as these costs are not “lavish or extravagant under the circumstances”. This election is available only to those who have received foreign earned income (defined later) as an employee.
Qualifying housing expenses include the following:
- Fair rental value of housing provided in the foreign country by the employer
- Household repairs
- Nonrefundable fees paid for securing the leasehold
- Qualifying housing expenses paid by an employer
- Real and personal property insurance
- Rental of furniture and household accessories
- Residential parking
- Utilities (other than telephone charges)
Qualifying housing expenses exclude the following:
- Amounts deductible by a tenant-stockholder in connection with cooperative housing
- Cost of a pay television
- Cost of buying or improving a house
- Cost of purchased furniture or household accessories
- Deductible interest and taxes (e.g., mortgage interest, real estate taxes)
- Depreciation expenses
- Domestic labor expenses (e.g., maids, gardeners)
- Principal payments on a mortgage
In addition, if the taxpayer’s family is required to reside in a separate abode overseas due to the “dangerous, unhealthful, or otherwise adverse living conditions” existing where the taxpayer is employed, the reasonable housing expenses of maintaining the second foreign household may be eligible for the housing cost exclusion.
The housing cost exclusion is equal to the excess of the “qualifying housing expenses” (generally capped at 30% of the maximum foreign earned income exclusion) over a “base housing amount”. The “base housing amount” is calculated as 16 percent of the maximum foreign earned income exclusion limitation.
If the housing expenses are incurred in a year in which the taxpayer begins or completes the foreign assignment, the limit on qualifying housing expenses and the base housing amount are reduced proportionately. Also, assuming both exclusions have been elected, the housing cost exclusion must be calculated first.
If both the taxpayer and spouse qualify for the foreign housing exclusion, properly figuring the benefits depends on whether separate households are maintained by the taxpayer and spouse.
Separate Households. If the taxpayer and spouse live apart and maintain separate households, both can claim the foreign housing exclusion if both of the following conditions are met:
- Taxpayer and spouse have different tax homes that are not within reasonable commuting distance of each other and,
- Neither spouse’s residence is within reasonable commuting distance of the other spouse’s tax home.
Each spouse claiming a housing exclusion must figure separately the part of the housing amount that is attributable to employer-provided amounts, based on his or her separate foreign earned income.
If the spouses’ tax homes, or one spouse’s residence and the other spouse’s tax home, are within a reasonable commuting distance of each other, only one spouse may exclude his or her housing cost amount. Regardless of whether the spouses file joint or separate returns, the amount of the housing cost exclusion must be determined separately for each spouse.
One Household. If the spouses reside together, and file a joint return, they may compute their housing cost exclusion either jointly or separately. If the spouses compute their housing cost exclusions separately, they may allocate the qualifying housing expenses to either of them or between them for the purpose of calculating separate housing cost exclusion, but each spouse claiming a housing cost exclusion must use his or her full base housing amount in such computation. If the spouses compute their housing cost exclusion jointly, then only one of the spouses may claim the housing cost exclusion.
Also, if the taxpayer and spouse have different periods of residence or presence and the one with the shorter period of residence or presence claims the exclusion or deduction, only the expenses attributable to that shorter period may be claimed.
If the spouses reside together and file separate returns, they must compute their housing cost exclusions separately.
Qualifying for the Exclusions
A U.S. citizen may qualify for the exclusions in two ways:
- By establishing himself or herself as a bona fide foreign resident for an uninterrupted period that includes an entire calendar year, or
- By being physically present in one or more foreign countries for 330 full days in any consecutive twelve-month period. In many cases, only the physical presence test is available to U.S. resident aliens (“green card” holders) since they are, by nature, bona fide residents of the United States.
The Internal Revenue Service can waive the time requirement for either the bona fide resident or physical presence test for those who must leave a foreign country due to “war, civil unrest or similar conditions precluding the normal conduct of business.” The list of countries to which this exception applies is strictly limited. A special provision denies the exclusions to individuals violating federal travel restrictions.
Foreign “Tax Home”
A prerequisite for either the bona fide residence or the physical presence test is that the taxpayer must establish a foreign tax home. A person’s tax home is generally defined as the location of his or her principal place of business rather than his or her abode or residence. A tax home normally must be established and maintained solely for reasons of employment. If a person has no principal place of business, his or her tax home is considered to be his or her regular abode. A taxpayer is not considered to have a foreign tax home for any period during which his or her abode remains in the United States. For example, a taxpayer who lives in Detroit but commutes daily to work in Windsor, Ontario, would ordinarily have his or her tax home in Windsor. Because the abode continues to be located in the United States, however, he or she would be ineligible for the exclusions. The Internal Revenue Service considers a new tax home to have been established if the taxpayer actually stays at the new place of employment for at least one year.
Equally important as the establishment of a foreign tax home and foreign place of employment is the taxpayer’s demonstration that he or she has established a foreign abode. “Abode” has been variously defined as one’s home, habitation, residence, domicile, or place of dwelling. It does not mean your principal place of business. “Abode” has a domestic rather than a vocational meaning and does not mean the same as “tax home.” The location of a taxpayer’s abode often will depend on where economic, family, and personal ties are maintained.
If a person meets the tests for establishing a foreign tax home and maintains his or her principal dwelling abroad, merely retaining ownership of the former U.S. residence will not cause him or her to have a U.S. abode for purposes of this rule. The result is the same even if the individual’s spouse or dependents continue to reside in the U.S. house. A final determination would depend on all other facts and circumstances. It should be noted that once a foreign tax home has been established, any reimbursements for housing or living expenses in that location may not be treated as “away from home” business expenses. Therefore, it is not possible to claim the exclusions for a period of time in which housing or living expenses reimbursements are taking place unless these reimbursements are included in the taxable compensation of the employee.
The lack of a precise definition of foreign tax home makes it very important that taxpayers document factors in their personal situation that support the establishment of a foreign tax home. As previously mentioned, a foreign tax home is absolutely necessary to qualify for the exclusions.
The term foreign country for purposes of the physical presence and bona fide foreign residence tests includes any territory under the sovereignty of a government other than that of the United States. It includes the territorial waters of the foreign country, as they are defined under U.S. laws, and the air space over the foreign country. U.S. possessions and territories are not considered foreign countries, nor are international waters.
Bona Fide Resident Test
To qualify as a bona fide foreign resident, a U.S. citizen must reside in a foreign country for at least an entire tax year—for a calendar-year taxpayer, one beginning before 1 January and ending after 31 December of the same year. For purposes of the bona fide residence test, it is crucial that the taxpayer establish foreign residence before 1 January. Being on the foreign company’s payroll is not sufficient; residency begins only when the taxpayer arrives in the foreign country with a genuine intent to establish a foreign residence.
The bona fide residence test requires that the taxpayer have an intent to reside in a foreign country, as supported by the related facts and circumstances. A person who travels abroad for a temporary period of time for a specific purpose is not usually considered a bona fide residence. Merely being in a foreign country for the required length of time is not sufficient; the required intent must exist. In determining a taxpayer’s intent to establish a foreign residence, U.S. courts have considered factors such as the duration and nature of the stay; whether the taxpayer’s U.S. house was sold, leased, or abandoned in favor of one in the foreign country; whether the taxpayer was accompanied by his or her family; the type of foreign visa obtained; the nature and degree of the taxpayer’s participation in the foreign community; the taxpayer’s command of the foreign language; and the location of the taxpayer’s economic interests. The fact that a taxpayer intends to return to the United States when the foreign assignment is over does not prevent his or her qualification as a bona fide residence.
Being considered a nonresident under foreign tax laws should not preclude a taxpayer from applying the bona fide residence test. Also, the possession of a tourist visa, with its implications that one is not a resident of the country under local immigration laws, does not in itself cause one to fail the bona fide residence test.
Being exempt from a foreign country’s income tax due to provisions of a tax treaty or international agreement does not alone disqualify a taxpayer from bona fide residence status. However, treaty provisions granting a U.S. person special privileges and immunities may so distinguish a U.S. citizen from other residents in the foreign country that they prevent the U.S. citizen from qualifying as a bona fide residence.
Another determining factor may be the manner in which the taxpayer presents his or her status to the foreign tax authorities. If the taxpayer gives a statement to the foreign tax authorities seeking exemption from the foreign country’s tax on the grounds that the taxpayer is not a resident of the foreign country, and if the tax authorities of the foreign country agree with the claim for exemption, then the taxpayer will not qualify under the bona fide residence test.
A change of foreign residence from one foreign country to another does not affect bona fide residence status. However, even temporary residence in the United States between foreign assignments can terminate bona fide residence status. Consequently, a taxpayer should maintain his or her foreign residence status until becoming a resident in a new foreign country.
Physical Presence Test
To qualify for the special foreign exclusion under the physical presence test, a U.S. citizen or resident alien must be physically present in a foreign country for 330 full days within any consecutive twelve-month period. A full day is a twenty-four-hour period beginning at midnight. Also, the taxpayer must have established a foreign tax home and a foreign abode as of that day. The time spent on or over international waters is not considered when counting the days a taxpayer was physically present in a foreign country unless the points of departure and arrival are both foreign countries. During such a trip, a person may visit the United States and, provided that the U.S. presence is for less than twenty-four hours, the day in the United States will still qualify as one of foreign physical presence.
The intent to establish a foreign residence is irrelevant for purposes of the physical presence test.
All that is required is that the taxpayer actually be present on foreign soil and be able to claim that his or her tax home and abode are outside the United States during the time of foreign presence.
An individual may qualify under the physical presence test regardless of whether he/she is subject to income tax in the foreign country.
Time spent in a foreign country in the employment of the U.S. government will count toward satisfaction of the 330-day requirement. However, income earned from the U.S. government may not be excluded.
Electing the Exclusions
The exclusions for foreign earned income and for housing costs are elective by the taxpayer.
Both elections are made on a federal tax return with Form 2555 attached that is filed no later than one year after the original due date. This due date will be determined without respect to the extension of time to file. As a result, a person may elect the exclusions for 2017 on a 2017 tax return filed no later than 15 April 2019. This special-election deadline does not extend the tax return’s due date or the time period for other provisions in the tax law.
Either of the elections may also be made on an amended tax return if the original return was filed on time. An amended tax return may be filed up to three years following the extended due date of the original return.
Either election may also be made on a late return filed after one year of its original due date provided one of the following conditions is met:
- The taxpayer owes no federal income tax after taking into account the exclusion and files Form 1040 with Form 2555, Foreign Earned Income, attached before or after the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion.
- The taxpayer owes federal income tax after taking into account the exclusion and files Form 1040 with Form 2555 attached before the Internal Revenue Service discovers that the taxpayer failed to elect the exclusion.
A taxpayer must make separate elections for the first year he or she intends to exclude foreign earned income or qualified housing expenses. Each election may be made regardless of whether the other is made.
Note: It may not always be to the taxpayer’s advantage to elect one or both of the exclusions. However, once elected, the exclusions must be applied in all later years unless they are revoked.
Revoking & Reelecting the Exclusions
A taxpayer may revoke either election in the current tax year or use an amended return to revoke elections made in previous years. However, this will also revoke the exclusion claimed in any intermediate year.
Should a taxpayer return to the United States and become a U.S. resident and then, a number of years later, move abroad again, the elections previously made would remain in effect. Should he or she decide in a later year to revoke either election, the revocation would be binding for that year and at least five (5) subsequent tax years.
A taxpayer can, however, reelect either exclusion within this six-year period by obtaining the Internal Revenue Service’s consent. In deciding whether to consent to a reelection, the Internal Revenue Service considers the period of the taxpayer’s U.S. residence, whether the individual moved from one foreign country to another with differing tax rates, and other relevant facts and circumstances. Internal Revenue Service consent is obtained by filing a request for a private letter ruling with the IRS National Office of Chief Counsel, a process which can be time-consuming and financially expensive.
Whether to make or revoke either exclusion should be discussed with a qualified tax professional before proceeding.
Foreign Earned Income
The basis for calculating the foreign earned income exclusion is the taxpayer’s foreign earned income for the year.
The tax law defines earned income as “wages, salaries, professional fees, and other amounts received as compensation” for rendering personal services. It includes all types of reimbursements, allowances, commissions, and in-kind payments associated with the provision of services, such as:
- Incentive payments relating to foreign assignments
- Cost-of-living and housing allowances
- Market value of employer-provided housing, automobiles, financial services, and so forth
- Dependent education
- Home leave
- S., state, and foreign income tax allowances
- Certain employer payment/reimbursement of expenses related to family members
Special rules exist for the following types of taxpayers:
- Operates as a sole proprietor or professional
- Members of foreign partnerships
- Artists, athletes and scientists
- Employees of the U.S. government
In order for earned income to be considered “foreign” it must be from sources within a foreign country that is earned during a period for which the individual qualifies to make an election (i.e., either the foreign earned income or foreign housing cost exclusions)”. Earned income is from sources within a foreign country if it is attributable to services performed by an individual in a foreign country or countries.
Foreign source income does not include items such as pension or annuity income, income paid to an employee by an employer which is the U.S. government or any U.S. government agency or instrumentality, income from a “nonexempt trust” or “nonqualified annuity,” interest, ordinary dividends, capital gains, or alimony.
Also, to qualify as foreign earned income, the income must not be received later than the end of the year following the year in which the services were performed. Consequently, payments for an employee’s salary, expense reimbursements, or tax equalization will not qualify for the exclusion if paid later than one year after the year in which the services were performed.
As noted above, to exclude the income from U.S. taxation, not only does it have to be earned income, the taxpayer must also establish that the income is from a foreign source. The source of compensation for the performance of personal services is determined on the basis of the place where the services are performed. Factors such as the place from which payment is made, the location of the employer, and the employee’s home base are not relevant.
Based on IRS-issued regulations, the source of compensation should be determined based on either a “time” or “geographical” basis.
The time basis requires all compensation other than certain listed fringe benefits (listed below) to be sourced based on days worked during the tax year. This category of income would include, among other items, salary, incentive compensation, equity-based compensation and taxable group term life insurance. This income would be sourced based on the ratio of foreign workdays over total workdays for the year.
The geographic basis sources income received in the form of certain fringe benefits based on the geographical work location for which it relates. The regulations list certain fringe benefits that should be sourced geographically, and set forth the following sourcing provisions:
- Housing: Sourced on the location of the individual’s principal place of work.
- Education: Sourced on the location of the individual’s principal place of work.
- Local transportation: Sourced on the location of the individual’s principal place of work.
- Foreign tax reimbursements: Sourced on the location of the jurisdiction that imposed the tax.
- Hazardous or hardship duty pay: Sourced based on the duty zone for which the fringe benefit was paid.
- Taxable moving expenses: Sourced on the location of the employee’s new principal place of work or former place of work if certain conditions are met.
Alternatively, a “facts and circumstances” basis may be used if it can be shown to the satisfaction of the Commissioner that this basis is more appropriate. This may occur, for example, when an employee’s compensation is tied to the performance of a specific action rather than earned ratably over a specific time period.
Some states have also published rules on sourcing which need to be considered in applying state income tax withholding rules and preparing state income tax returns.
Critical: Because accurate attribution and sourcing of a taxpayer’s income is a critical step in determining the amount of earned income eligible to be excluded from U.S. taxation, taxpayers must maintain a daily record (commonly referred to as a “Travel Calendar” or “Calendar”) of their physical whereabouts (i.e. country or countries of presence) and activity (i.e., working or not working) for each day of the tax year. This same daily activity record is also required to properly compute the amount of foreign tax credit, if any, a taxpayer may claim either in addition to – or in lieu of – the foreign exclusions. The Foreign Tax Credit & Deduction are discussed in Chapter 2.
Tax Treaty – Resourcing of Compensation
The U.S. has concluded income tax treaties with a number of other countries. Many of these treaties contain a provision within them that permit a taxpayer to “re-source” as foreign income that would otherwise be U.S.-source income using normal sourcing rules. The intent of this provision is to help avoid double taxation of the same income by the U.S. and the foreign country.