What is the foreign earned income exclusion (FEIE)?
The foreign earned income exclusion (FEIE) allows qualifying U.S. expatriates to exclude a certain amount of their foreign income on their U.S. tax return to lower their taxable income. This allows U.S. taxpayers earning foreign income to avoid U.S. taxation on a portion of their income. The limit on the amount deductible changes on an annual basis, in order to reflect inflation.
How to qualify?
To qualify for exclusion under the FEIE, you must have foreign earned income and your tax home must be in a foreign country. In addition, you must meet one of the following criteria:
- You are a U.S. citizen who is a bona fide resident of a foreign country for uninterrupted period of an entire calendar year (meet the bona fide residence test);
- A U.S. resident alien who is a citizen/ national of a country that has an income tax treaty with the U.S., and is a bona fide resident of a foreign country for uninterrupted period of an entire calendar year;
A U.S. citizen or resident alien physically present in a foreign country for at least 330 full foreign days during a 12-month consecutive period (meet the physical presence test).
What can I claim under the foreign earned income exclusion (FEIE)?
You can only exclude income received for services outside of the U.S., employed or independently contracting or freelancing. This includes wages, salaries, professional fees, bonuses, allowances and foreign benefits. The IRS has an online Interactive Tax Assistant tool to help you figure out whether your foreign earned income is eligible for exclusion.
Income accrued in the U.S. before moving overseas, including dividends, interest, capital gains, pension annuities and rental income, do not qualify for exclusion and will be subject to full U.S. tax. Moreover, amounts received for personal services cannot be excluded. Someone travelling out to Dubai mid-year in July, having been working and earning in the U.S. from January to June, could only exclude what they have earned for their services in Dubai and not during the January to June period.
What if I’m self-employed?
If you qualify, you may claim for the exclusion on foreign earned self-employment income. The amount excluded will deduct from your income tax but will not deduct from self-employment tax, unless your professional services took place in a country with a totalisation agreement.
An individual coming to the Middle East and acquiring different types of income on a self-employed basis, may wonder if they can get out of paying U.S. social security and Medi-Care taxes. If the country has a totalisation agreement with the U.S., they are not required to pay self-employment taxes. Few key countries, however, do not have totalisation agreements with the U.S., including the UAE and most Middle Eastern countries. If engaging in any self-employment in the UAE, you will most likely be subject to U.S. self-employment taxes.
I want more information about Foreign Earned Income Exclusion
What is the exclusion limit?
The limit for the maximum exclusion amount is adjusted annually with inflation. For the tax year 2019, the maximum exclusion amount is $105,900 USD per qualifying person. If you earned $112,000 in 2018, you subtract $105,900, leaving $6,100 to be taxed by the U.S.
For the tax year 2020, the maximum exclusion amount is $107,600 USD. If two married individuals working abroad meet the criteria (bona fide residence test or physical presence test), they can together exclude up to $215,200 for the 2020 tax year.
If, say, you travel to Dubai in July and start earning foreign income then, you may only be eligible for half of this exclusion amount. If the period in which you qualify is only part of the year, you must adjust the limit based on the number of qualifying days. Multiply the maximum exclusion amount by the number of qualifying days, and divide the result by the number of days in the year.
For example: if you have established a tax home and bona fide residence in a foreign country on July 1 2019, until January 31 2021, you qualify for 183 days within the 2019 tax year (July 1 to December 31, 2019).
$105,900 x 183 = 19,379,700 / 365 = 53,095.06
Your maximum exclusion for the 2019 tax year is $53,095.06 USD.
Itemised Deductions and Standard Deductions
So what happens if you earn, say, $125,000 USD and want to reduce what is left over the maximum exclusion amount before paying tax? It is possible to reduce what is left through Itemised Deductions or Standard Deductions.
Single filers for the 2019 tax year have $12,200 USD of standard deduction to wipe other types of income. A single filer can claim back on expenses including state taxes, real estate taxes, personal property taxes, medical expenses, mortgage interest and/or contributions to U.S. charitable organisations. If these expenses exceed the standard deduction you are better off claiming Itemised Deduction, in order to write off the remaining amount of income from U.S. taxes.
There used to be considerably more qualifying deductions and expenses, but now there is only a handful. A significant expense that could be claimed previously was moving and storage expenses in the U.S. Before 2018, these could be claimed as an adjustment in a tax return. Now, based on changes part of the Trump tax Reform, these expenses have been repealed and no longer are deductible.
It is also possible for childcare expenses to be claimed as credit against U.S. tax. An expat couple hiring a nanny in Dubai for the year could claim childcare expenses as credit, with a dollar for dollar reduction. However, the maximum amount of childcare expenses eligible is $3,000 USD per child ($6,000 USD for two or more qualifying dependents) and is multiplied by a certain percentage dependent upon income.
Claiming for school fees is dependent on the age of the child. Below kindergarten level can be claimed as childcare expenses, but beyond this level is not deductible.
How do I claim?
It is important to note that the exclusion is not automatic, and you must file an income tax return and with IRS Form 2555. It is a common misconception that earning less than the maximum exclusion amount annually means you will not pay tax and thus not have to file a tax return. Even if you believe your foreign earned income to be below the exclusion amount, you are still required to file an income tax return. The threshold for filing a tax return if you are married to a non-American is just $5 USD. Even if you are not working, you could still receive $5 USD worth of interest and therefore need to file.
What about capital gains?
You may be wondering whether you have to pay tax on capital gains, including profits on stocks. Itemised deductions and/or standard deductions reduce the amount of your taxable income, therefore meaning that income from other sources does not necessarily mean tax.
If a single filer received $5,000 USD worth of profit from stocks, it is less than the threshold and therefore not taxed. However, if you were to buy $20,000 USD worth of stock and sell it for $40,000 USD, making $20,000 USD profit, some of this gain will be taxed. Anything in excess of the standard deduction ($12,200 USD as a single filer) will be taxed. Moreover, your capital gains will be assessed as either long-term or short-term. Short-term capital gains are taxed at ordinary rates, while long-term gains of more than 1 year are taxed at a preferential tax rate.
Contact us at Expat Tax Online to learn more.