When you are living and working outside of the United States you may be able to exclude the first ~$100,000 of earned income from your U.S. tax return. If you qualify for this exclusion (Do I qualify for the foreign earned income exclusion article coming soon) and you have wages of $100,000 or less, you will ultimately be able to exclude all of those earnings and you will not owe any tax on that income. THIS DOES NOT MEAN YOU DON’T NEED TO FILE A TAX RETURN. Very often people assume that because this exclusion results in the exclusion of all of their income that they do not need to file. This is incorrect and the potential consequences for this belief are severe, as the IRS can preclude you from claiming this exclusion if they select your returns for audit and you have not claimed this exclusion on a timely filed return.
If you haven’t claimed the foreign earned income exclusion on a timely filed original return, unless you are under audit, you still have time to file returns for past years and take advantage of this exclusion. There are special rules that apply to late filed returns that are claiming the exclusion and it is important that these rules are observed or you could jeopardize your ability to claim the exclusion.
When attempting to determine your eligibility for the foreign earned income exclusion, you’ll come across two different tests, the physical presence test and the bona fide residence test.
The Physical Presence Test
The physical presence test is exactly how it sounds, a test based on your physical presence in the foreign country. The target is 330 days spent within foreign countries. There are a number of specific rules that impact this calculation, the first, and possibly most useful is the ability to decide the 365 day period to which the test is applied. This means that even if you spent too many days in the U.S. during any calendar year, you can adjust the 365 day period off of the calendar year, enabling you to pass the physical presence test. For example, if you were in the U.S. for all of January and February of 2018 but did not spend any more days in the U.S. in 2018 or 2019, you would be under the required number of foreign days for the calendar year but if you instead set your year from March 1st 2018 to February 28th 2019, you will pass the physical presence test. It is important to note that this does not impact the rest of your tax return. Changing your year for purposes of the physical presence test does not change your year for income tax purposes and you still must include your calendar year worldwide income on your return.
The Bona Fide Residence Test
This is an entirely different test with an entirely different set of rules and requirements, but this test is not as clear cut as the physical presence test Under this test you can claim the foreign earned income exclusion if you can establish that you were a bona fide resident of the foreign country for the entire year, and you establish this by answering some very specific questions on Part II of Form 2555, questions like: did members of your family live with you in the foreign country? Did you pay tax to the foreign country? What were the circumstances of your living situation in the foreign country, i.e. did you own a home, rent an apartment, rent a room etc?
The Exclusion
If you qualify under either of these tests, you’ll be eligible to claim the foreign earned income exclusion. The amount of the exclusion will depend, in part, on the application of these tests, to a maximum exclusion of $107,600 for tax year 2020. This exclusion is only the first available exclusion through Form 2555, the second exclusion is the housing exclusion, explained here (future article coming soon.)