Tax Benefits of the Foreign Earned Income Exclusion
Commentary on the Tax Cuts and Jobs Act (TCJA) often focuses on the new territorial tax provision that allows U.S. corporations operating abroad to exempt certain foreign-source income from U.S. taxation, but there has long been a provision available to U.S. individuals working abroad to exempt foreign earnings from U.S. taxation. The foreign earned income exclusion can provide numerous benefits to U.S. citizens and residents living overseas.
The exclusion allows U.S. individuals working abroad to exclude from taxation a certain amount of foreign earned income each year, plus a housing amount. This means U.S. individuals living in low-tax foreign jurisdictions can benefit from the lower tax rate and avoid the cumbersome calculations tied to the foreign tax credit.
To qualify for benefits under section 911 of the Code, the U.S. citizen or resident must meet the definition of a qualified individual. A qualified individual is defined as follows:
- Individual is physically present in a foreign country for at least 330 days during any 12-month period or is a bona fide resident of a foreign country for an uninterrupted period that includes an entire taxable year, and
- Individual’s tax home is in a foreign country (i.e., principal or regular place of business).
The exclusion is only applicable to foreign-source income earned during the period in which the taxpayer meets the foreign tax home requirement, while also meeting either the bona fide foreign resident test or the 330-day physical presence test.
Up until this year, taxpayers who lived and worked in designated combat zones failed to qualify for the foreign earned income exclusion because their tax home was in the United States. However, under the Bipartisan Budget Act of 2018, contractors providing support to U.S. Armed Forces in designated combat zones are now eligible to claim the exclusion (even if their tax home is in the United States).
The maximum amount of foreign earned income that is eligible for the exclusion is adjusted annually for inflation.
The maximum foreign earned income amount is also prorated for the number of qualifying days in a taxable year. For example, if John Doe met the definition of a qualified individual for the 2017 tax year, but only has 325 qualifying days, his maximum foreign earned income exclusion would be the 2017 maximum/indexed amount of $102,100 (see chart above) multiplied by 325/365.
When calculating foreign earned income, employment-related allowances, such as housing and automobile allowances, also qualify for the exclusion if the allowance represents compensation for services performed abroad during the qualifying period. Further, a deferred payment, such as a bonus, qualifies for the exclusion if it is received before the close of the taxable year following the year in which it was earned.
The exclusion for housing costs equals the excess of eligible expenses incurred over a base amount. Eligible expenses include:
- Property insurance
- Rental of furniture and accessories
- Household repairs
The base housing amount is 16% of the maximum/indexed amount for foreign earned income during the tax year. This means that the base housing amount for 2018 would be calculated as follows:
16% x $103,900 maximum/indexed amount for 2018 =
$16,624 base housing amount
||Base Amount for Housing
Housing expenses in excess of the base amount are eligible for the housing exclusion, but such expenses may not exceed a certain limit. The limit on housing expenses is tied to a taxpayer’s location. For most locations, the limit is set at 30% of the maximum/indexed foreign earned income amount for the tax year.
The taxpayer cannot claim a foreign tax credit for income taxes related to the excluded foreign earned income and any deductions allocable to excluded foreign earned income are disallowed. Also, if a taxpayer claims the foreign earned income exclusion, the housing exclusion, or both, the individual must figure the tax on the remaining non-excluded income using the tax rates that would have applied had the individual not claimed the exclusions.
Taxpayers electing the foreign earned income exclusion must file Form 2555, Foreign Earned Income, with the IRS. This form establishes the taxpayer’s status as a qualified individual, calculates the taxpayer’s foreign earned income, and provides the total amount of the exclusion to be carried forward onto the taxpayer’s Form 1040.
In summary, the foreign earned income exclusion can provide both quantitative and qualitative benefits to U.S. individuals living abroad. While the foreign tax credit is the primary mechanism for mitigating double taxation, this special exemption for foreign-source income allows taxpayers working in low-tax jurisdictions to benefit from lower taxes abroad and avoid the many complexities tied to the foreign tax credit.
Tara Fisher has been practicing international tax for nearly 20 years. Her professional background includes working for the U.S. Congress Joint Committee on Taxation, the national tax practice of PricewaterhouseCoopers, the University of Pittsburgh, and American University in Washington D.C. She is a licensed CPA and holds both an undergraduate and graduate degree in accounting from the University of Virginia.