Foreign earned income exclusion

IRS fact sheet explains foreign earned income exclusion
IRS Fact Sheet May 2008

Mike Habib, EA

IRS has issued a fact sheet that explains the foreign earned income exclusion rules.

    Observation: Although the fact sheet is a valuable summary of the complex foreign earned income rules that apply starting with the 2006 tax year, it does not contain references to Code sections or IRS guidance. We have added them for the reader’s convenience.

Background. As noted in the fact sheet, U.S. citizens and resident aliens are taxed on their worldwide income, whether the person lives inside or outside of the U.S. However, qualifying U.S. citizens and resident aliens who live and work abroad may be able to exclude from their income all or part of their foreign salary or wages, or amounts received as compensation for their personal services. In addition, they may also qualify to exclude or deduct certain foreign housing costs. (Code Sec. 911)

General rule. To qualify for the foreign earned income exclusion, a U.S. citizen or resident alien must:

    • have foreign earned income (income received for working in a foreign country);
    • have a tax home in a foreign country; and
    • meet either the bona fide residence test or the physical presence test. (Code Sec. 911)

    Exclusion amounts and limits. The foreign earned income exclusion amount is adjusted annually for inflation. For 2008, the maximum foreign earned income exclusion is up to $87,600 per qualifying person. If taxpayers are married and both spouses (1) work abroad and (2) meet either the bona fide residence test or the physical presence test, each one can choose the foreign earned income exclusion. Together, they can exclude as much as $175,200 for the 2008 tax year. (Code Sec. 911(b)(2)(D), Rev Proc 2007-66, 2007-45 IRB 970, Sec. 3.30)

    In addition to the foreign earned income exclusion, qualifying individuals may also choose to exclude or deduct from their foreign earned income a foreign housing amount. The amount of qualified housing expenses eligible for the housing exclusion and housing deduction is limited, generally, to 30% of the maximum foreign earned income exclusion. For 2008, the housing amount limitation is $26,280 for the tax year. However, the limit will vary depending on where the qualifying individual’s foreign tax home is located and the number of qualifying days in the tax year. (Code Sec. 911(c)(2)) The foreign earned income exclusion is limited to the actual foreign earned income minus the foreign housing exclusion. Therefore, to exclude a foreign housing amount, the qualifying individual must first figure the foreign housing exclusion before determining the amount for the foreign earned income exclusion. (Code Sec. 911(d)(7))

    How to claim the exclusion. Since the foreign earned income exclusion is voluntary, qualifying individuals must choose to claim it. The foreign earned income exclusion and the foreign housing cost amount exclusion are claimed and figured using Form 2555, which must be attached to Form 1040. However, if only the foreign earned income exclusion is claimed, a shorter Form 2555-EZ may be used instead. Once the choice is made to exclude foreign earned income, that choice remains in effect for the year the election is made and all later years, unless revoked. (Code Sec. 911(e))

    What isn’t foreign earned income. Foreign earned income does not include the following amounts:

      • Pay received as a military or civilian employee of the U.S. Government or any of its agencies.
      • Pay for services conducted in international waters (not a foreign country).
      • Pay in specific combat zones, as designated by a Presidential Executive Order, that is excludable from income.
      • Payments received after the end of the tax year following the year in which the services that earned the income were performed.
      • The value of meals and lodging that are excluded from income because it was furnished for the convenience of the employer.
      • Pension or annuity payments, including social security benefits. (Code Sec. 911(b)(1)(B))

      Self-employment income. A qualifying individual may claim the foreign earned income exclusion on foreign earned self-employment income. The excluded amount will reduce his regular income tax, but will not reduce his self-employment tax. Also, the foreign housing deduction instead of a foreign housing exclusion may be claimed.

      Figuring the tax. A qualifying individual claiming the foreign earned income exclusion, the housing exclusion, or both, must figure the tax on the remaining non-excluded income using the tax rates that would have applied had the individual not claimed the exclusions. (Code Sec. 911(f))

      Foreign tax credit or deduction. Once the foreign earned income exclusion is chosen, a foreign tax credit, or deduction for taxes, cannot be claimed on the income that can be excluded. (Code Sec. 911(d)(6)) If a foreign tax credit or tax deduction is claimed for any of the foreign taxes on the excluded income, the foreign earned income exclusion may be considered revoked.

      Earned income credit. Once the foreign earned income exclusion is claimed, the earned income credit cannot be claimed for that year. (Code Sec. 32(c)(1)(C))

      Timing of election. Generally, a qualifying individual’s initial choice of the foreign earned income exclusion must be made with one of the following income tax returns:

        • a return filed by the due date (including any extensions);
        • a return amending a timely-filed return;
        • amended returns generally must be filed by the later of 3 years after the filing date of the original return or 2 years after the tax is paid; or
        • a return filed within 1 year from the original due date of the return (determined without regard to any extensions). (Reg. § 1.911-7(a)(2)(i)(D))

        Revoking the exclusion. A qualifying individual can revoke an election to claim the foreign earned income exclusion for any year. This is done by attaching a statement to the tax return revoking one or more previously made choices. The statement must specify which choice(s) are being revoked, as the election to exclude foreign earned income and the election to exclude foreign housing amounts must be revoked separately. If an election is revoked, and within 5 years the qualifying individual wishes to again choose the same exclusion, he must apply for approval by requesting a ruling from IRS. (Code Sec. 911(e)(2))

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