Today you will learn about the foreign earned income exclusion which is a tax law that is unique for American taxpayers who do not work on American soil. If you happen to earn income from foreign sources and or self employment you may be able to exclude a part of this earned income from the U.S. federal income tax.
In order to be able to benefit from this law, you must be employed and physically reside outside the USA and you must meet the requirements for either the Bona Fide Resident or Physical Residence test. If you can meet these rules you may be eligible to exclude up to $104,100 in income you have earned from foreign sources as of the last 2018 tax year.
About the Bona Fide Residence Test
To be considered a “bona fide resident” of another country is judged that you have lived in that country for an uninterrupted period that includes an entire tax year. What this means is is that you must have lived on foreign soil from January 1 through December 31 to qualify for the bona fide resident you must be out of the U.S for one full calendar year. You are allowed to take brief trips and vacations outside of the foreign country as long as they are short. You are also allowed to take brief visits to the U.S. as long as you clearly intend to go back to the foreign country. You are also not considered to be a bona fide resident of a foreign country if you submit a statement to that country stating you are not a resident and that government does not find you a subject of their tax laws. Your income can’t be excluded in both countries.
About The Physical Presence Test
To pass this test you must be physically in a foreign country for at least 330 full days in a consecutive 12-month time period. You are allowed to live and work in different countries but you must be physically present in them for at least 330 full days. A full day is considered to be 24 hours and days of arriving or departing a foreign country does not count in the physical presence test. This test may be considered easier because the qualifying time period can be in any 12-month period which makes it more lenient.
The only waiver that exists with these two rules is if you are forced to leave the country because of warfare, civil unrest or adverse conditions. You will have to provide proof that you intended to stay and meet the time requirements if you weren’t impacted by these conditions.
About types of income and tax exclusions explained
The foreign earned income exclusion can only be used for income earned from performing services as an employee or as an independent contractor. Earned income is viewed as any monies earned from professional fees, wages, salaries and any other income earned as payment for service. People who are self-employed may also qualify for the foreign earned income exclusion as well. The only exclusions of earned income are from federal income tax. This exclusion doesn’t reduce self-employment-tax either. A taxpayers income tax is calculated by the total income tax you would pay on your total income before taking the foreign income exclusion into effect. You can deduct the taxes on the amount of foreign earned income that is deducted. What is left is the amount of your federal income tax liability.
When it comes to choosing any consecutive 12-month period for the foreign earned income exclusion when using the physical presence test can make a situation of your amount of exclusion has to be spread over two taxable years. If this happens the amount of the total maximum exclusion in a year may be prorated. If this applies to you use the number of days you were present in a foreign country during the tax year. The exclusion is then calculated by the ratio of the time you were physically present on foreign soil. The prorated exclusion amount won’t exceed the total allowable exclusion. The only other way the prorated exclusion applies if you are forced to leave the country due to civil unrest.
Another exclusion includes amounts paid by your employer for housing. This includes any money paid directly to you or someone on your behalf for housing, rent, education for children or tax equalisation payments.
Ultimately the foreign earnings exclusion tax law can be used by almost anyone who is employed outside the U.S. and they can benefit from up to a $104,100 tax discount every year.
Watch the Explainer Video
Check out the video below that helps explain the FEIE law in less than ten minutes!