Living Outside the United States
If you are a U.S. citizen or resident alien and if you meet the following tests, you can elect the "foreign earned income exclusion." First, you must have a "tax home" in a foreign country. This means your main place of business or employment must be in a foreign country on either a permanent or indefinite basis. Your principal home can still be in the U.S., but if your foreign assignment is merely temporary, you will not qualify for the exclusion. Even if your foreign assignment is temporary and you do not qualify for the exclusion, lodging and meals expenses of a temporary assignment can be deductible travel expenses. Your assignment will not be considered temporary, however, if it's for more than a year.
Secondly, while having the above tax home, you must either meet the bona fide foreign residence test or the foreign physical presence test.
Bona Fide Residence Test
To meet the bona fide foreign residence test, you must be a bona fide resident of one or more foreign countries for an uninterrupted period fully covering at least one calendar tax year (i.e., Jan. through Dec.). Broadly speaking, you're a bona fide resident if you have the intent to live there for the time being. You can still intend to return to live in the U.S. eventually. Also, temporary brief trips back for vacation or business will not cause you to fail this test.
Physical Presence Test
For the physical presence test, you must be physically present in a foreign country for 330 full days during a period of 12 consecutive months. For this test, the months do not have to cover an entire calendar tax year but they can run, for example, from June through May of the next year. Interestingly enough, the same periods may be used to qualify for successive years, or the days may overlap from one year to the next. In this way you can use some of the same days as in the prior year to qualify for the current year.
Earned Income Exclusion
If you qualify under the above tests, you can exclude the lesser of (1) $105,900 or (2) your foreign earned income for the year. (If your spouse qualifies as well, an exclusion is separately determined for him or her.) Remember that the exclusion applies to earned income only, and for example income paid by the U.S. government and income received as a pension or annuity is not included in foreign earned income. The $105,900 amount must be computed on a daily basis if you do not satisfy the tests for the entire year. If, for example, you qualify for the exclusion under the bona fide residence test for the last 40 days of 2018 (and then for all of 2019). For 2018, the maximum exclusion is 40/365 times $105,900, which equals $11,605. (For 2019, the entire $105,900 -indexed for inflation- exclusion is available.) A similar adjustment would be made if your qualifying days under the physical presence test were less than 365 for the year.
Tax Planning Considerations
- If you are an employee who expects to work in countries that have a lower tax rate than the U.S., the election should be made.
- If you are engaged in a profitable trade or business in a foreign country that has a lower tax rate than the U.S., the foreign earned income exclusion should be made.
- If your tax liability can be offset completely by a foreign tax credit, the election shouldn't be made. Due to the offset, there is no advantage to making the election, but by making it, you may restrict future flexibility.
- If you are engaged in a trade or business in a foreign country that produces a net loss, claiming the foreign earned income exclusion will result in a reduction of expenses attributed to the excluded income. This may reduce the loss available to offset other worldwide income to your disadvantage.
Foreign Housing Cost Exclusion
If your employer covers all or part of your foreign housing costs you may also qualify for a foreign housing cost exclusion. (In some cases, however, this may reduce your foreign earned income exclusion.)