U.S. citizens and residents who are living in a foreign country are subject to the same income tax laws that apply to citizens and residents living in the U.S.  But there is a provision in the tax code that allows U.S. citizens and residents to exclude a certain amount of foreign earned income from their taxable income for U.S. tax purposes.

These special tax rules apply to U.S. citizens and residents.  For U.S. tax purposes, persons who are not U.S. citizens are considered to be either resident aliens or nonresident aliens.  Internal Revenue Service (IRS) Publication 519, U.S. Tax Guide for Aliens, explains the criteria that are used to determine whether an individual is considered to be a resident or nonresident, and the resulting tax consequences of that determination.

The importance of determining whether you are considered a U.S. resident, for these purposes, is to determine your eligibility for the foreign earned income exclusion and foreign housing exclusion or deduction, which applies only to U.S. citizens and residents.

Who Is A U.S. Resident for Income Tax Purposes?

A resident alien is an individual who is not a U.S. citizen, but who meets either the green card test or the substantial presence test.

• You meet the green card test and are a U.S. resident if you hold a green card and are a lawful permanent resident of the United States at any time during the year.
• You meet the substantial presence test and are a U.S. resident if you are physically present in the United States for at least 31 days during the current calendar year, and for at least 183 days during the current calendar year and the two preceding calendar years.  For purposes of meeting this test, you can only count 1/3 of your days of physical presence in the first preceding year, and only 1/6 of your days in the second preceding year.

Example of Substantial Physical Presence Test for U.S. Residents

You were physically present in the U.S. for 45 days in the current year, 180 days last year, and 240 days the year before.  You meet the 31-day physical presence test for the current year, with your 45 days of presence.  But you can only use 60 days from last year (1/3 of 180 days) and only 40 days from the year before (1/6 of 240).  Your total (45 this year + 60 for last year + 40 for the year before = 145, which is less than the required 183 days.  You would not be considered a U.S. resident for tax purposes, under the substantial physical presence test.

Closer Connection to a Foreign Country

Even if you meet the substantial physical presence test, you could still be considered a nonresident alien if:

• You are present in the U.S. for less than 183 days during the current year.
• You maintain a tax home in a foreign country, and
• You have a closer connection to that foreign country than you do to the United States.

Tax Effect for Residents and Nonresidents

If as a result of these tests, it is determined that you are a U.S. resident, you generally have the same tax treatment as a U.S. citizen, which means that you are subject to U.S. income tax on your worldwide income, but are eligible to exclude part or all of your foreign earned income.  If it is determined that you are a nonresident, different tax rules apply, and you should see IRS Publication 519.  A nonresident does not qualify to exclude foreign earned income, but at the same time, a nonresident is generally only subject to U.S. income tax on U.S. source income.

What is the Foreign Earned Income Exclusion?

The foreign income exclusion allows U.S. citizens and residents to exclude from their income for U.S. tax purposes, the income they earn for personal services performed in a foreign country, up to a certain maximum amount per year.  This limit is periodically changed and can be found in IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, or in the instructions for Form 2555, Foreign Earned Income, which is the form that has to be filed to claim this exclusion.

What is the Foreign Housing Exclusion or Deduction?

In addition to the foreign earned income exclusion, you may be able to exclude a certain amount of your income used to pay housing expenses, or deduct from your income part of your housing expenses while living abroad.  The foreign housing exclusion applies to employees, and the foreign housing deduction applies to self-employed individuals.

Who Qualifies?

In order to qualify for the foreign earned income exclusion and the foreign housing exclusion or deduction, you must meet the following requirements:

1. You must have your “tax home” in a foreign country,
2. You must have earned income from personal services performed in a foreign country, and
3. You must meet the bona ride resident or physical presence test:
1. A U.S. citizen qualifies if he or she is considered a bona fide resident of one or more foreign countries for an uninterrupted period that includes an entire tax year.
2. A U.S. resident alien qualifies if he or she is a citizen or national of a country with which the United States has an income tax treaty, and is a bona fide resident of one or more foreign countries for an uninterrupted period that includes an entire tax year.
3. A U.S. citizen or a U.S. resident alien also qualifies if he or she is physically present in one or more foreign countries for at least 330 days during a period of 12 consecutive months.

These minimum time requirements may be waived if you had to leave a country due to war, civil unrest, or similar adverse conditions.

Tax Home Test

Your tax home must be in a foreign country, or countries, throughout the period of bona fide residence or physical presence, whichever applies.  For this purpose, your period of physical presence is the 330 full days during which you were present in a foreign country, and not the 12 consecutive months during which those days occurred.

The location of your tax home will depend on the circumstances.  Normally, your tax home is considered to be the general area of your regular or principal place of business, employment, or post of duty, regardless of where you maintain your family residence.  If you do not have a regular or principal place of business because of the nature of your trade or business, your tax home may then be the place where you normally live.

You are not considered to have a tax home in a foreign country for any period during which your “abode” is in the United States.  Abode is more of a domestic term and depends on where you maintain your economic, family, and personal ties.  However, if while working abroad you are temporarily present in the United States, or you maintain a dwelling in the United States (whether or not that dwelling is used by your spouse and dependents), it does not necessarily mean that your abode is in the United States during that time.

The location of your tax home may depend on whether your assignment in a foreign country is temporary or indefinite.  Normally, if you expect your assignment in one location outside the U.S. to last one year or less, it is considered temporary.  In this case, you could deduct your travel, meals, and lodging expenses according to the tax rules for deducting expenses while traveling away from home on business.  If the assignment is expected to last more than one year, it is indefinite.  In this case, you could not deduct travel, lodging and meals, but you may qualify for the foreign earned income exclusion, and the foreign housing exclusion or deduction.

Bona Fide Residence Test

To meet this test, you must be one of the following:

• A U.S. citizen who is a bona fide resident of a foreign country, or countries, for an uninterrupted period that includes an entire tax year or
• A U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country, or countries, for an uninterrupted period that includes an entire tax year. 

See IRS Publication 901, U.S. Tax Treaties, for a list of countries with which the United States has an income tax treaty in effect.

There are no specific rules that determine whether you are a bona fide resident of a foreign country.   Bona fide residence is determined in each individual case, taking into account factors such as your intention, the purpose of your trip, and the length and nature of your stay.  Going to a foreign country to work does not necessarily make you a bona fide resident.  Generally, if you go to another country for an extended and indefinite period, and you set up permanent quarters there for yourself and your family, you have established a residence, even though you intend to eventually return to the U.S.

 Generally, if you go to a foreign country for a definite, temporary purpose and return to the United States after you accomplish it, you are not a bona fide resident of the foreign country.    If accomplishing the purpose requires an extended, indefinite stay, and you make your home in the foreign country, you may be a bona fide resident.

Physical Presence Test

To meet this test, you must be a U.S. citizen or resident alien who is physically present in a foreign country or countries, for at least 330 full days during 12 consecutive months. 

This test is based only on physical presence and does not depend on the type of residence you establish, or the purpose of your stay.  You do not have to be in a foreign country only for employment purposes the entire time – vacation periods also count toward meeting the total number of days.

The 330 days do not have to be consecutive, and can be interrupted by periods when you are traveling over international waters or are otherwise not in a foreign country.  To figure the minimum of 330 full days of presence, add all separate periods you were present in a foreign country during the 12-month period. 

A nonresident alien who, with a U.S. citizen or U.S. resident alien spouse, chooses to be taxed as a resident of the United States may qualify under this test if the time requirements are met.

Figuring the 12-Month Period

For purposes of meeting the physical presence test, the following apply with regard to the 12-month period:

• The 12-month period can begin on any date.
• The 12 months must be consecutive.
• The 12-month period does not have to begin on your first full day in a foreign country, or end on the day you leave the country.  You can use any 12-month period in which the 330 days fall.
• 12-month periods can overlap when determining 12-month periods as part of a longer stay in a foreign country or countries.

Example of overlapping 12-month periods:

• You are assigned to work in a foreign country from January 1 of one year until August 31 of the following year – a 20 month period.
• You return to the U.S. for a vacation of 30 days in April of each year.
• Your first 12-month period is from January 1 through December 31 of the first calendar year.
• Your second 12-month period is from September 1 of the first calendar year through August 31 of the second calendar year.
• You are physically present for 335 days in each 12-month period, so the entire 20-month period qualifies for the foreign earned income exclusion.

What is Foreign Earned Income?

Foreign earned income includes wages, salaries, professional fees, and other compensation received for personal services you performed in a foreign country during the period for which you meet the tax home test and either the bona fide residence test or the physical presence test. 

Allowances and Reimbursements

Earned income also includes allowances or reimbursements, such as the following:

• Cost of living allowances
• Overseas differential
• Family allowances
• Home leave allowance
• Allowance for living quarters
• Reimbursement of moving expenses or moving allowance
• Reimbursement of education expenses or education allowance

Non-Cash Income

Earned income also includes the fair market value of non-cash income (such as lodging, meals, or a car).  But it does not include meals and lodging you exclude from income because they are at the convenience of your employer.

Earnings from Self-Employment

If you operate an unincorporated trade or business in which both personal services and capital were material income-producing factors, a reasonable amount of compensation for your personal services will be considered earned income.

The amount treated as earned income, however, may not be more than 30% of your share of the net profits from the trade or business, after subtracting the deduction for one-half of your self-employment tax.

If capital is not an income-producing factor and personal services produced the business income, the 30% rule does not apply.  All your gross earnings are considered to be earned income.

Amounts Not Included in Foreign Earned Income

Foreign earned income does not include any of the following types of income:

• Amounts that are actually a distribution of corporate earnings or profits rather than a reasonable allowance as compensation for your personal services
• Pension and annuity income
• Interest, ordinary dividends, capital gains, alimony, etc.
• Portion of a prior year's moving expense deduction allocable to the current year that is included in your current year's gross income
• Amounts paid to you by the U.S. Government or any of its agencies if you were an employee of the U.S. Government
• Amounts received after the end of the tax year following the tax year in which you performed the services
• Amounts you must include in gross income because of your employer's contributions to a nonexempt employees' trust or to a nonqualified annuity contract.

Source of Income

Since the exclusion applies to foreign source earned income, you must determine the source of your income.  Generally, the source is the place where you performed the services for which you received the income.  Where or how you are paid does not affect the source of your income.  For example, if you are working overseas but are paid through a direct deposit from a U.S. bank to your U.S. bank account, your income is still foreign source income.

If you receive income that is partly for work done in the U.S. and partly for work done in a foreign country, you must allocate your income.  Most of the time, you can do this based on the number of days you worked in each country.

Choosing the Exclusion(s)

Once you determine that you qualify, you take the foreign earned income exclusion, the foreign housing exclusion, or deduction by completing the appropriate parts of Form 2555 and filing it with your Form 1040.  If you have a foreign housing amount to exclude, you exclude that first, and then determine your foreign earned income exclusion.

Married Taxpayers

If you are married and both you and your spouse work abroad, and you both qualify, you can each take up to the maximum amount of the exclusion.  Both of you do not have to meet the same test to qualify; you can each qualify under either the bona fide resident test or the physical presence test.

No Deductions or Credits on Excluded Income

If you elect to take the foreign earned income exclusion, you cannot take any deduction or credit related to the income you exclude.  This includes any expenses, losses, or other deductions that would normally be allocable to the income.

Making the Election

Once you choose to claim an exclusion, that choice remains in effect for that year and all future years unless it is revoked.  To revoke your choice, you must attach a statement to your return for the first year you do not wish to claim the exclusion(s).  And, if you revoke your choice, you cannot claim the exclusion(s) again for your next 5 tax years without IRS approval.

Form 2555EZ

You may be able to use the simpler Form 2555-EZ if:

• none of your foreign earned income was from self-employment,
• your total foreign earned income did not exceed the maximum amount of the exclusion for that particular year,
• you do not have any business or moving expenses, and
• you do not claim the housing exclusion or deduction.

Foreign Housing Exclusion or Deduction

The foreign housing exclusion applies to amounts that are considered to be provided by your employer to pay for your housing abroad.  The housing deduction applies only to self-employment earnings.

Foreign Housing Exclusion

The amount you can take as a foreign housing exclusion is the total of your housing expenses for the year, minus a base amount, according to a U.S. Government scale for foreign assignments.  This base amount is built into the calculation of your housing exclusion as a separate line on Form 2555, so you only need to calculate your total housing expenses.  If you claim the housing exclusion, you cannot use Form 2555EZ.

Housing Expenses

Housing expenses include the reasonable costs of the following, during the period you qualify for the foreign earned income exclusion:

• Rent, or the fair market value of housing provided by your employer
• Repairs
• Utilities
• Insurance
• Occupancy taxes
• Non-refundable fees for obtaining a lease
• Rental of furniture and accessories
• Residential parking

Housing expenses do not include the following:

• Cost of purchasing property
• Deductible interest and taxes
• Domestic labor (maids, gardeners)
• Pay television subscriptions
• Improvements or additions that increase the value of the property or prolong its life (capital expenditures)
• Purchased furniture or accessories
• Depreciation or amortization

If you do not have self-employment earnings, all your income is considered to have been provided by your employer, and you can exclude all your housing expenses, up to the limit for the foreign earned income and housing exclusion.

Foreign Housing Deduction

If all your foreign source income is from self-employment, you take the foreign housing deduction instead of the exclusion.  You can deduct the same housing expenses as for the exclusion.

If you have self-employment earnings and income from an employer, you must allocate your housing expenses between the housing exclusion and the housing deduction.  Your housing deduction cannot be more than your foreign earned income minus the total of your foreign earned income exclusion and your housing exclusion (up to the maximum).  If you cannot deduct all your housing expenses because of this limit, you can carry over the excess to the following year only.

When To File

You are automatically granted a 2-month extension of time to file if, on the due date of your return, you live outside the United States and Puerto Rico and your tax home is outside the United States and Puerto Rico.  If you take this extension, you must attach a statement to your return explaining that you meet these two conditions.

The automatic 2-month extension also applies to paying the tax.  However, interest is charged on the unpaid tax from the regular due date (April 15) until it is paid.

Special Extension of Time 

The first year you plan to take the foreign earned income exclusion and/or the housing exclusion or deduction, you may not expect to qualify until after the automatic 2-month extension period.  If this occurs, you may apply for an extension until a date after you expect to qualify.  Complete and file Form 2350 before the due date of your return.

Withholding Tax

If you work abroad for a U.S. employer, your employer is obligated to withhold U.S. income tax from your pay.  But if you expect to qualify for the foreign earned income exclusion or the foreign housing exclusion or deduction, you can choose not to have U.S. income tax withheld.  You do this by presenting a statement to your employer, indicating that you will meet either the bona fide residence test or the physical presence test.  You can use your own statement, or you can use Form 673, Statement for Claiming Exemption from Withholding on Foreign Earned Income Eligible for the Exclusion(s) Provided by Section 911.  This is a standard statement prepared by the IRS for this purpose, and can be downloaded from the IRS website. 

Earned Income Credit