Reducing Your US Tax Bill Using The Foreign Earned Income Exclusion - A Guide for Expats in 2023

“America is a land of taxation that was founded to avoid taxation.” - Laurence J. Peter

In this article, we’re going to provide a comprehensive overview of the Foreign Earned Income Exclusion, one of the primary means of reducing your US tax bill as an American living overseas.

In this article, you’ll learn about:

• What is the Foreign Earned Income Exclusion?

• How to qualify for the Foreign Earned Income Exclusion

• What is a tax home?

• What is the Physical Presence Test?

• What is the Bona Fide Residence Test?

• What is foreign earned income?

• How to claim the Foreign Earned Income Exclusion

• Filing IRS Form 2555 instructions

• What is the Foreign Housing Exclusion or Deduction?

• Foreign Earned Income Exclusion FAQs

The Foreign Earned Income Exclusion is an IRS provision that allows Americans living abroad to exclude their earned income from US tax.

Unfortunately, however, the FEIE isn’t a silver bullet that automatically cancels an expat’s US tax bill.

This is because the FEIE isn’t applied automatically, but has to be claimed each year by filing a Form 2555 when you file your US federal taxes.

Furthermore, there are a number of restrictions on who can claim it and what income can be excluded, so whether or not it’s worth claiming the FEIE depends on each expat’s individual circumstances.

For example, many expats benefit more from claiming the Foreign Tax Credit instead; in fact, under certain circumstances, it’s even worth claiming both.

Another potential drawback of claiming the FEIE is that it only lets you exclude up to a certain amount of your income. Every year, the IRS adjusts the maximum amount you can exclude for inflation, illustrated as follows:

• In 2020, the maximum was $107,600

• In 2021, the maximum was $108,700

• In 2022, the maximum was $112,000

• In 2023, the maximum is $120,000

You can revoke your choice to claim the FEIE in any tax year by attaching a statement to your current tax return or, to an amended prior year return detailing your decision. It’s notable that if revoked, you may not be able to claim the FEIE for the next 5 tax years. There is a process to request approval from the IRS if you wish to claim the FEIE within that 5 year period however, it can be complex, time consuming and doesn’t always result in a successful outcome. Therefore, when revoking it’s important to consider your anticipated tax residence and earned income position for the proceeding 5 year years. - Josh Reeves, Moore DM

To establish whether you can claim the Foreign Earned Income Exclusion, there are several concepts that allow the IRS to determine whether you qualify as living abroad.

These concepts include where your Tax Home is, and whether you meet either the Physical Presence Test, or the Bona Fide Residence Test.

We’re going to look at these concepts in more depth, but the purpose of them is to ensure that the FEIE is only claimed by Americans who genuinely live abroad.

The other factor is the types of income you have, as the FEIE only lets you exclude earned income.

Earned income includes all income from employment, self-employment, or any other compensation for a service you’ve provided in the same tax year, and therefore also includes tips, bonuses, and benefits in kind such as accommodation, transport costs, and meals.

To claim the Foreign Earned Income Exclusion, your Tax Home must be in a foreign country.

US overseas territories and dependencies aren’t considered to be foreign countries.

Your Tax Home is normally the place where you are when you work, assuming you work in one place. If you work in different places, for example if you travel a lot, then the place where you normally live is considered your Tax Home.

So if you live in the US but are posted abroad for 6 months, it is unlikely that you will be able to qualify for the FEIE, as your Tax Home will still be in the US. If you move abroad and set up a home in another country on the other hand, then you have moved your Tax Home, and you therefore qualify. The difference can come down to whether or not you can prove that you have settled in another country, such as by opening a bank account, joining local clubs, owning a car, or shipping your belongings, perhaps. Giving up or renting out your old home in the US is also a helpful indicator.

Pilots and mariners who spend the majority of their time in the air or at sea outside the US don’t normally qualify for the FEIE, as they don’t move Tax Home to another country. This is also true for US astronauts, such as those on the International Space Station. Famously, Jack Swigert, one of the astronauts on the Apollo 13 mission, suddenly realized that he hadn’t filed for an extension after lift off, and radioed Houston in a panic. He soon had bigger issues to think about, of course.

Once you have established that your Tax Home is abroad, to claim the FEIE you also have to meet either the Physical Presence Test or the Bona Fide Residence Test.

The Physical Presence Test means that you spent at least 330 days outside the US and in another foreign country in a 365 day period. This period normally refers to a tax year, but it doesn’t have to, so if you move abroad (or back to the US) in the middle of a year, for example, you can claim the FEIE for the next (or previous) 365 day period.

330 days means 330 full days, meaning that days in which you are travelling from or to the US don’t count.

Days when you aren’t in any other country, such as if you were at sea on a cruise, also don’t count as being outside the US for the purposes of claiming the FEIE, either.

Alternatively, you can qualify for the FEIE through meeting the Bona Fide Residence Test.

The Bona Fide Residence Test means you are resident in another country for at least a year, including a tax year, and with the intention to stay there for an extended period or indefinitely.

The definition is deliberately vague, and the onus is on the expat to demonstrate that they are a resident of another country to meet the test.

Typically, this means proving that your permanent home is in a foreign country and you have an active bank account there, and you have the legal right to reside there, or you pay foreign taxes there.

Once you have met one of the two tests for living abroad, you can claim the FEIE, but you can only exclude foreign earned income.

Earned income, as mentioned above, includes salaries, wages, commissions, bonuses, professional fees, self-employment income, and tips.

Unearned or passive income can’t be excluded using the FEIE however, including rents, interest, dividends, pensions, gambling winnings, and social security payments

Earned income is considered foreign earned income if your Tax Home is outside the US, regardless of where in the world your income is paid, including the US. The only exception is any income you earn when physically working in the US, which isn’t considered foreign earned income.

If you claim the Foreign Earned Income Exclusion and exclude all of your income, you may not be able to make contributions to a Roth IRA retirement plan, as contributions are allowable based on your taxable income.

Once you have established that both you and your income qualify, to claim the Foreign Earned Income Exclusion you have to file IRS Form 2555 at the same time as your Form 1040 every year (i.e. the same filing deadlines and extension rules apply).

Form 2555 is a relatively short 3-page form, however most expats seek assistance from an expat tax specialist to ensure that they get planning advice as well as fill in the form correctly.

Part I requests details about you and your employer. You then fill in either Part II or Part III, depending whether you are using the Bona Fide Residence Test (Part II) or the Physical Presence Test (Part III).

In Part IV, you enter details about your foreign earned income amounts and your expenses. These figures correspond with those you put on Form 1040.

Part V is for if you are also claiming the Foreign Housing Exclusion or Deduction (more details about this are below). If you are, enter further details in Part VI.

The final three parts, VII, VIII, and IX, are for the exclusion calculations, using the figures from the previous sections.

If you are claiming the Foreign Earned Income Exclusion, are renting your home abroad, and your income exceeds the FEIE maximum threshold, you can also claim the Foreign Housing Exclusion (or the Foreign Housing Deduction if you’re self-employed) to exclude more of your income from US tax. The FHE is also claimed using Form 2555.

The Foreign Housing Exclusion (or Deduction) lets you exclude a proportion of your unavoidable housing expenses, such as rent and utilities.

The IRS uses a complex formula to determine the amount of your housing expenses that you can exclude (or deduct), which also takes into account where you live, as rental costs are higher in some places than others.

There are other credits and exclusions available to expats too, depending on your circumstances, so always discuss your options with your expat tax professional.

No, the FEIE just lets you reduce US federal income tax, so self-employed expats are still liable to pay US self-employment taxes if they claim the FEIE. These may however be covered by a double taxation agreement between the US and the host country where the expat lives.

In theory yes, however expats can’t apply the FEIE and the FTC to the same income. So for example if you live and are employed in a foreign country and you also receive rental income from an apartment in the US that is also taxed in the country where you live, it could make sense to claim both and apply the FEIE to your employment income and the FTC to your rental income. Whether this would be the best approach would depend on the specific details of your situation, though.

No, expat parents can’t normally claim the FEIE and the refundable part of the US Child Tax Credit, so it often makes more sense for expat parents to claim the Foreign Tax Credit rather than the FEIE, assuming doing so will also reduce their US tax bill to zero.

If you have any questions, don't hesitate to contact us.

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