The Foreign Income Exclusion

The Foreign Income Exclusion is one of the three main mechanisms the IRS has in place to help protect taxpayers from dual taxation while living abroad.  The Foreign Income Exclusion allows qualified taxpayers to exclude up to $92,900 (for the 2011 tax year) from their foreign earned income when filing their expatriate tax return.  The exclusion is claimed via Form 2555 and is attached to Form 1040 for expats when filing with the IRS.

The Foreign Housing Allowance

The Foreign Housing Allowance is in place to allow qualified expatriate taxpayers to deduct some of the additional expenses associated with living overseas from their foreign earned income. The allowance is either calculated at the basic rate of up to 30% of the $92,900 Foreign Income Exclusion, or can be calculated up to the rates set for a specific location.  Locations with higher living costs such as London, Hong Kong, or Paris are eligible for higher allowances in order to make up for the higher cost of living.  This allowance is also reported via Form 2555 and can be attached to your expatriate tax return.

The Foreign Tax Credit 

The last big mechanism the IRS has in place to protect taxpayers from dual taxation is the Foreign Tax Credit.  This credit allows taxpayers to deduct taxes paid to a foreign government from their US tax liability on a dollar to dollar basis.  For example, if you owe $1,000 for the 2011 tax year to the IRS, but paid the equivalent of $1,500 to the UK’s HRMC, your US tax liability would be eliminated. The Foreign Tax Credit is reported via Form 1116 and must be attached to your expatriate tax return in order to be deducted from your US tax liability.

Qualify for the Foreign Income Exclusion

In order to qualify for these big deductions and credits, the IRS has certain requirements that must be met to apply these money saving mechanisms to an expatriate tax return.  The taxpayer must be a US citizen or resident alien, have foreign earned income, and meet the requirements of either the Physical Presence Test of the Bona Fide Resident Test. 

The Physical Presence Test requires that an individual be physically present in a foreign country or countries for a total of 330 full days.  The devil is in the details when it comes to the Physical Presence Test, and there are some details to be careful about. 

Travel time between the United States or any other foreign country does not count as being physically present in a foreign country.  So, if you take a flight from New York to London and do not arrive in London until 3AM the following day, this does not count as a full day towards your Physical Presence Test as you were not physically present in the United Kingdom for a full 24 hour day.  You must have been present at midnight in order for the day to qualify as a full day towards the Physical Presence Test. 

The Bona Fide Resident Test requires that you are actually a resident of a foreign country, but also evaluates your future intent.  To meet the Bona Fide Resident Test, you must have lived in a foreign country for at least one entire year, be considered a resident for tax purposes in that foreign country and have no intensions of leaving the country on a permanent basis.  The tricky part is proving your intensions – and the burden of proof falls on you, the taxpayer.  While it does not mean you can never leave the country, it does mean that you have no immediate intensions of returning to the United States to live. 

If you have questions about qualifying for the Foreign Income Exclusion, the Foreign Tax Credit, or the Foreign Housing Allowance, it is suggested that you talk to a qualified expat CPA in order to ensure you can take advantage of these money saving mechanisms on your expatriate tax return.