Foreign Earned Income Exclusion and the Bona Fide Residence Test
by: Anthony Parent
“Foreign Earned Income” and “Bona Fide Residence Tests” can sound like a bit of a mouthful, but if you spend time living, studying, or working abroad, they can save you money when it comes to tax time. We’ll explain what each of these means and let you know how you can reduce your tax burden.
The Foreign Earned Income Exclusion
Typically, U.S. citizens and residents are taxed on their worldwide income, wherever it is earned. However, if you meet certain requirements, you can exclude a certain amount of your foreign earnings from your income when you submit your tax return. The amounts you may be able to exclude are $104,100 for the 2018 tax year, and $105,900 in 2019. This amount increases every year in line with inflation. To claim these exclusions, you need to show that you have been resident and earned money in countries outside the U.S.
What is Included and Excluded in Foreign Earned Income?
The Foreign Earned Income Exclusion can be applied as follows:
It is only applied to active income that you earn for performing a job, from wages or salary, or as money you pay yourself while self-employed.
This can apply to money paid to you by a U.S. company, providing you were outside of the country for a specific length of time.
The exclusion does not apply to other types of income like retirement income, investment income, real estate income, social security benefits, and other types of income.
Certain other types of income don’t apply including as an employee of the U.S. government, or payments received after the end of the tax year.
Note that self-employment tax may still be due on income, wherever it is earned, depending on whether the United States has a totalization agreement with your country of residence.
The Bona Fide IRS Residence Test
There are a number of factors that the IRS uses to determine if you have a bona fide residence in another country and can claim the Foreign Earned Income Exclusion. You must be a U.S. citizen 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.
“You meet the bona fide residence test if you are a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.”
They go on to say: “Questions of bona fide residence are determined on a case-by-case basis, taking into account such factors as your intention or the purpose of your trip and the nature and length of your stay abroad. You must show the Internal Revenue Service (IRS) that you have been a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year. The IRS decides whether you qualify as a bona fide resident of a foreign country largely on the basis of facts you report on Form 2555, Foreign Earned Income. “
Facts that the IRS will use to determine if you are a bona fide resident include:
The reason for you staying abroad.
The intended length of your stay.
Whether your stay was uninterrupted.
Whether your stay lasted an entire tax year.
Whether you are subject to the income tax laws of the foreign country.
Your domicile in the U.S.
How Tax is Calculated When Applying the Foreign Earned Income Exclusion
The IRS will tax you based on the total amount earned abroad less the exclusion amount ($105,900 in 2019).
For example, if you earn less than $105,900, there will likely be no tax to pay if you were outside the U.S. for the tax year. But, if you have $140,000 of earned, taxable income, you would still pay tax on the $140,000 less $105,900 = $34,100. Note that you would pay tax on this amount as if you had earned $140,000, meaning the higher marginal rate will apply, so you will pay a higher tax rate than someone who had simply earned $34,100.
Foreign Housing Credit
The Foreign Earned Income Exclusion is not the only benefit you can get from living in another country. The IRS also allows you to deduct part of your housing costs while overseas. You can typically exclude anything in excess of 16 percent of the total amount of the Foriegn Earned Income Exclusion that you have claimed.
For example, if you have $120,000 of Foreign Earned Income Exclusion in 2019 and claim the maximum amount of $105,900, you can also exclude housing amounts you have paid in excess of 16 percent of $105,900, which works out to $16,944. So, if you paid $30,000 in housing costs, you could potentially exclude $13,056 of that.
This can be a real bonus, especially if you’re living somewhere with high housing costs like Hong Kong or London.
International tax matters can be complex, and you want to have an expert on side. If you need help or representation for your international tax affairs, please get in touch.