This article is directed toward Americans who are earning income outside of the United States and would like to reduce their tax responsibility to Uncle Sam.
That opening sentence will likely prompt more than a few readers to ask themselves, “Why would I pay taxes to the American government if I live and work in another country?”
That’s an excellent question and the answer is simple: the United States is one of only two countries on the planet that taxes its non-resident citizens on their global income. The other country is the small African nation of Eritrea.
I took the liberty of providing a map for those readers who are unfamiliar with Eritrea (indicated in green):
Now that we have the geography out of the way, let’s move on to the actual topic of the article.
Foreign Earned Income Exclusion (FEIE)
This is how it works: if you meet the requirements below, you can exclude foreign earned income from your gross income on your U.S. tax return. The maximum amount of the exclusion depends on the tax year and increases each year based on inflation.
Here are the maximum exemptions for the indicated tax years:
As you can see, that’s a substantial amount of money.
According to the IRS, in order to qualify for the income exclusion you must 1) have foreign earned income, 2) your tax home must be in a foreign country and 3) you must be one of the following:
- A U.S. citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year,
- A U.S. citizen or a U.S. resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.
The first option, being a bona fide resident of a foreign country, is not as easy to prove as you might think. It’s not a standard “yes” or “no” type of question and it can be a little subjective.
For more information about proving that you’re a bona fide foreign resident, click HERE.
The second option, the physical presence test, is much easier to prove and that’s the recommended route for most people.
You’ll need to track the exact dates that you were in the United States during the 12 month period. If you even go one day over, you’ll lose the exemption. Click HERE to learn more.
If you are employed by the U.S. Government or one of its agencies, you cannot claim the exemption.
The FEIE only applies to the income that you earn by actually providing services in the foreign country: salaries, wages, commissions and tips.
It does not apply to passive income, which is referred to as unearned income by the IRS. The following are examples of unearned income: pension and annuity payments; social security payments; capital gains; interest; gambling winnings; and alimony.
Generally speaking, rental income is unearned income. If you perform personal services in connection with the production of rent, up to 30% of your net rental income can be considered earned income.
Here is an example taken directly from IRS Publication 54 (2016):
Larry Smith, a U.S. citizen living in Australia, owns and operates a rooming house in Sydney. If he is operating the rooming house as a business that requires capital and personal services, he can consider up to 30% of net rental income as earned income. On the other hand, if he just owns the rooming house and performs no personal services connected with its operation, except perhaps making minor repairs and collecting rents, none of his net income from the house is considered earned income. It is all unearned income.
Bad News for the Self-Employed
If you’re self-employed, you can still claim the exemption on income; however, you’ll still be responsible to pay self-employment tax on the income. In other words, Uncle Sam will be asking for 15.3% of your reported foreign income. Yep, that one stings a little.
Let’s Wrap This Up
Taxes can be a little more complicated once you live and work in a foreign country. It’s always advisable to speak with a professional who specializes in preparing taxes for expats.