The foreign earned income exclusion prevents double taxation by excluding the income from U.S, taxation. The United States will tax your income earned worldwide. However, if you are an American expat, this means you are taxed twice on this income. The income you receive overseas, sees the foreign country tax, and can be taxed again by the IRS. 

Breaking Down Foreign Earned Income Exclusion

The foreign earned income exclusion is elected on IRS tax Form 2555. Furthermore, taxpayers who claim this exclusion cannot deduct any business expenses incurred relative to the foreign income, make domestic retirement plan contributions of any kind that are based on this income or claim the foreign tax credit or deduction for any taxes paid to a foreign government on this income.

Furthermore, you must meet specific qualifications to claim the foreign earned income exclusion.

  1. You are a U.S citizen or resident alien. A resident alien is a foreign person and is a permanent resident without citizenship of the country in which they reside. To fall under this classification in the United States, a person needs to either have a current green card or have had one during the last calendar year.
  2. You have a qualifying presence in a foreign country. Qualifying presence status is met by satisfying the Bonafide Resident Test by being a resident in the country for a full tax year. You may also fulfill the Physical Presence Test by being physically present there for at least 330 days within a 12-month consecutive period. 
  3. You have paid foreign taxes on foreign earned income. You have foreign earned income if you receive wages through employment or compensation through self-employment for services you perform in a foreign country. The income you receive from foreign source pensions, investments, alimony, or gambling is not foreign earned income.

There is a statutory maximum exclusion amount plus a foreign housing amount which limits the exclusion. It is prorated if the number of qualifying days in a foreign country is less than a full tax year. 

The foreign housing amount is the housing costs you paid with foreign earned income that exceeds 16% of the maximum exclusion, or base, amount. This amount has a cap amount at 30% of the maximum exclusion amount. The foreign housing amount is taken as exclusion by employees and as a deduction by the self-employed individuals. For the 2018 tax year, the maximum exclusion amount is $104,100, the base amount is $16,656, and the cap amount is $31,230.

Example of Foreign Earned Income Exclusion

Let’s see how the foreign earned income exclusion works. MP is an American working in Vietnam. They lived in Hanoi for 345 days of the tax year and were absent for 10 days on a trip home for Thanksgiving. They earned a salary of $225,000 and paid $30,596 of it to lease a flat for the year. MP paid $75,000 in Vietnamese income tax and owed $81,000 in US income tax on this income. The upshot is that their foreign earned income is being taxed twice.

Since MP is a U.S. citizen who paid foreign taxes on income they earned during 335 qualifying days in a foreign country, they may elect to exclude the foreign earned income from their U.S. taxable income.

MP’s 2018 exclusion is $109,608. ($104,100 maximum exclusion amount + $15,040 foreign housing amount x 335/365 ratio of qualifying days to total days).

MP’s 2018 foreign housing amount is $15,040. ($30,596 in housing costs - $15,556 base amount). Since $15,040 is less than the $31,230 cap amount, no further reduction is necessary.

The foreign earned income exclusion allows MP to exclude $109,608 from their taxable income. But, $115,392 remains included and, since they have paid foreign taxes of $37,000 and still owes U.S. taxes of $36,000, it remains double taxed. 

MP should take a $37,000 nonrefundable foreign tax credit against the $36,000 U.S. taxes they owe. As long as they timely file Form 2553 to elect the foreign earned income exclusion and Form 1116 claiming the foreign tax credit, they will not owe U.S. taxes on the foreign income.