foreign income exclusion

What is the foreign income exclusion?

Foreign income exclusion is designed to prevent double taxation by excluding income taxed in another country from U.S. taxation. The Internal Revenue Service (IRS) will tax your worldwide income. However, if you are a U.S. expat, this means you are taxed twice on this income. Income you receive overseas will see foreign tax and can be taxed again by the IRS.

key takeaways

  • Foreign income exclusion is designed to prevent double taxation by excluding income taxed in another country from U.S. taxation.
  • To qualify for the credit, you must be a U.S. citizen and a bona fide resident of one or more foreign countries for an uninterrupted period that includes the entire tax year.
  • Resident aliens who are citizens or nationals of countries with which the United States has a valid income tax treaty may also qualify.
  • If you live and work abroad, it is important to know all the rules and regulations.
  • The foreign housing amount represents the cost of housing you paid abroad with foreign income. It must exceed 16% of the maximum excluded amount or base amount.

Understanding Foreign Income Exclusions

Foreign income exclusions are selected on IRS Form 2555. In addition, taxpayers claiming this exclusion make any form of domestic retirement plan contributions based on that income, or claim foreign tax credits or deductions for any taxes paid to foreign governments on that income.

You must meet certain qualifications to apply for the foreign income exclusion.

  1. You are a U.S. citizen or resident alien. A resident alien is a foreigner who is a permanent resident without the citizenship of his country of residence. To fall into this classification in the United States, a person needs to have a current green card or have a green card in the previous calendar year.
  2. You have a qualifying presence in a foreign country. Eligible presence status is met by meeting the Bonafide residency test by living in the country for a full tax year. You can also complete the physical presence test by being physically present for at least 330 days in a 12-month period.
  3. You have overseas income. You have foreign income if you are paid through employment or paid for services performed abroad through self-employment. Your income from foreign-sourced pensions, investments, alimony or gambling is not foreign income.

foreign housing amount

There is a statutory maximum exclusion amount plus the foreign housing amount that limits exclusions. Prorated if the number of qualifying days in a foreign country is less than a full tax year.

The foreign housing amount is the cost of housing you pay when your foreign income exceeds 16% of the maximum excluded or basic amount. This amount is capped at 30% of the maximum excluded amount. Foreign housing amounts are considered exclusions for employees and deductions for self-employed individuals.

For the 2021 tax year, the maximum exemption is $108,700 and will reach $112,000 in 2022.

Example of Foreign Income Exclusion

Let’s see how the foreign income exclusion works. MP is an American working in Vietnam. They lived in Hanoi 345 days during the tax year and were away 10 days when they came home for Thanksgiving. Their salary was $225,000, of which $30,596 was spent on renting the apartment for the year. MP paid $75,000 in Vietnamese income tax and owed $81,000 in U.S. income tax. The result is that their overseas income is taxed twice.

Because MPs are U.S. citizens who paid foreign taxes on their earned income within the 335 qualifying days in the foreign country, they may choose to exclude foreign earned income from their U.S. taxable income.

The deductible for members of Congress in 2018 was $111,000. (Maximum exclusion amount of $105,900 + foreign housing amount of $15,040 x 335/365 ratio of qualifying days to total days). MP’s 2018 foreign housing amount was $15,040. (Housing Costs $30,596 – Base Amount $16,944). Since $13,652 is below the cap amount of $31,770, no further reduction is required. The foreign income exclusion allows members of Congress to exclude $111,000 from their taxable income. But still includes $114,000 and is still double taxed because they have paid $37,000 in foreign taxes and still owe $36,000 in U.S. taxes.

MPs should receive a non-refundable foreign tax credit of $37,000 from the $36,000 in U.S. taxes they owe. As long as they promptly file Form 2555 to elect to exclude foreign income and file Form 1116 to claim a foreign tax credit, they will not owe U.S. taxes on foreign income.

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