Foreign earned income exclusions, so it’s time that we write a post talking specifically to the people who are U.S. citizens but have decided to take a job in a foreign country.
Because let’s face it, when you decide to take a job opportunity in another country, that job usually pays you a lot of money to do it.
And of course, the more money you make, the more you are usually taxed, right?
Well no, there are actually foreign earned income exclusions that can help you avoid paying taxes on certain things.
So in this post, we want to talk about foreign income and foreign housing so that we can help those who are working out of the country or considering it.
But before we discuss these foreign earned income exclusions, let’s define first what foreign earned income is.
What is Foreign Earned Income?
Foreign earned income is simply the income you receive for services you performed in a foreign country during which your tax home is in a foreign country.
What are Foreign Earned Income Exclusions?
So the foreign earned income exclusions mean that you do not have to pay U.S. federal income taxes on that foreign earned income…
…which again is the money that you made while out of the country.
There is a limit of how much foreign earned income can be excluded, which for 2021 is up to $108,700. But in general, it’s been around $100,000 for the last few years.
So for example, we once had a client who worked in Kuwait as a contractor where he helped with the extraction of oil. And he made a 6-figure income doing so.
But, he did not have to pay taxes on a large chunk of his income, thanks to the foreign earned income exclusions.
However, there are two tests that you have to pass to confirm your foreign income status, which we will talk about in a second.
What is Earned Income vs Unearned Income?
Now let’s talk about what is classified as earned income and what is classified as unearned income.
And this is important to know whether you work in a foreign country or not.
This would be salaries and wages, commissions, bonuses, professional fees (if you’re a contractor), and any tips received.
This would be dividends, interest, capital gains, gambling winnings, alimony, social security benefits, pensions, and annuities. As you can tell unearned income is more so from passive income or investments.
This one would be business profits, royalties, rents and scholarships, and fellowships. These could fall into earned or unearned income depending on how the money was made.
So that is a general, high-level overview. But, there are still some exceptions of things that are not included in foreign earned income.
What is Not Foreign Earned Income
For example, if you receive pay as an employee of the U.S. government, this does not apply to military personnel.
If you work in international waters or airspace, but your primary job is in the US, it is not included as foreign income.
Pay you would get that would be considered unearned income such as the value of meals paid by your employer are not considered to be eligible for the foreign earned income exclusions.
So the key takeaway here is that, yes, there are some exceptions for foreign earned income exclusions, even if you technically work and live in another country.
Now let’s talk about two tests that you have to pass that basically prove with high certainty that you indeed do qualify for foreign earned income exclusions.
This again basically means, you don’t have to pay taxes on that foreign income.
Foreign Earned Income Exclusions Tests
1. Bona Fide Residence Test
First off, this test only applies to U.S. citizens or U.S. resident aliens who are regarded as U.S. citizens.
You can pass this test if you are a bona fide resident of a foreign country, or countries, for an uninterrupted period of time that includes an entire tax year.
The keyword here is an “uninterrupted” period of time because if you go to work in a foreign country for a specified period of time, you ordinarily will not be regarded as a bona fide resident of the country.
That is even if you work there for one tax year or longer.
So with the bona fide residence test, you basically are taking a job, plan to actively work there, without plans to leave and you stay there for at least one tax year.
If that’s you, then you can pass the test
If you are audited, they will make the determination of if you qualify by looking at your situation such as:
- your intention or purpose of being in the foreign country, or
- your activities while in the foreign country,
…just to name a few determining factors.
2. Physical Presence Test
This one is a little bit easier to understand.
So you simply need to be physically present in a foreign country (or countries) for a full 330 days during a period of 12 consecutive months.
Unlike with the bona fide resident test, the physical presence test does not depend on whether or not you establish a residence, your intentions about turning to the United States the natural, or the purpose of your stay aboard.
Again, you simply need to be in the foreign country for a full 330 days.
That means you have roughly 35 days where you could be physically present in the U.S.
And just to note, a full day is clarified as a full 24 hours.
So, if you’re thinking about working half a day and coming back to the U.S. that would use up one of those 35 days you have.
Now at this point, you should know what foreign earned income is, what the foreign earned income exclusions are, the difference between earned income and unearned income, and lastly, you know the two tests that can help you qualify.
So let’s bring all this home by looking at a foreign earned income exclusion example with numbers so you can run your calculations.
Foreign Earned Income Exclusion Example
Here’s an example from what the IRS gives us.
So let’s say you are a U.S. citizen, who is a bona fide resident in a foreign country and working in a foreign country as a mining engineer. Your salary is $76,800 per year.
In addition to salary, you also receive a $12,000 allowance for the cost of living and education.
And, your employment contract did not indicate that you were entitled to these allowances only while outside of the U.S.
That would make your total income $88,000.
So you go on to work 5-days a week, and after subtracting vacation you have 240 workdays a year. On top of that, you worked in the U.S. for 30 workdays.
To figure out what your U.S. source income is you would take the 30 workdays in the U.S. and divide it by the 240 workdays in the foreign country then multiply that by your total income.
And you would get $11,100 of U.S. source earned income.
30/240 x $88,000 = $11,100
So there you have it, a real calculation.
Now if you still need some help determining your status and your numbers, you can also use the IRS’s tool called Interactive Tax Assistant.
This will help you determine whether the income earned in a foreign country is eligible to be excluded from income reported on your U.S. federal income tax return.
And that’s it! We hope this post helped you better understand what foreign earned income exclusions are, and how to know if you are qualified for it.