What is a foreign earned income exclusion? Who can avail of this tax benefit on his/her income tax return? You can claim this tax benefit or in other words avoid double taxation if you require to file a U.S. tax return simply because you are a U.S. citizen or you were a U.S. resident for tax purposes in the year of filing. In this article, we are going to discuss in detail what this exclusion is and on what basis you can claim.
U.S. tax filing
Under the US tax, all US citizens or residents of the United States have to file an income tax return every year on form 1040 and comply with FABAR reporting requirements, regardless of their residency status. As a resident of the US, you are subject to the same U.S. income tax laws that apply to U.S. citizens and resident aliens living in the United States, and you report your worldwide income on your US tax return in the USA.
Exclude your foreign earned income:
However, under the US tax system, you may qualify to exclude your foreign earned income from your gross income and/or entitled to housing exclusion or deduction for the part of your qualifying housing expenses from your income or treat a limited amount of income used for qualifying housing expenses as not taxable by the United States.
However, the foreign income exclusion in the tax year 2020 is limited to the amount of $107,600.00 under the US tax system. This limit is adjusted by IRS year over year based on inflation.
To claim Foreign Earned Income Exclusion, you must be:
To qualify, you need to meet these two tests; 1. Tax home test, and 2. Either the bona fide residence test or the physical presence test.
You need to file your us tax return on time, including any extensions to claim your foreign earned income exclusion, . Once you choose to claim the foreign income exclusion on your tax return, this choice will apply to all of your future tax returns unless you revoke it. Once you revoke your choice of foreign income exclusion, you can not claim the foreign income exclusion for the next five years unless it is approved by IRS.
Under the US tax system if you are working for the Governments office or military different rules will apply and you may not be entitled to claim these deductions.
Your Tax Home
Under the US tax system, your place of business and or employment can be considered as your tax home regardless of your family residence. However, if you do not have a regular place of business and or employment, your tax home can be the place where you generally live. In this scenario factors that can be considered are the place where your family lives, your dependent’s lives, your personal and economic ties. To meet the test, your tax home must be in a foreign country, throughout the calendar year of your bona fide residence, or throughout your physical presence, whichever applies.
Bona fide residence test
US tax system, a US Citizen meets the bona fide residence test generally when you were uninterruptedly present throughout the calendar year in your tax home. That means you have to be present in a foreign country or foreign countries from January 01 to December 31. The day or days you are present in the USA is not counted as you are present in a foreign country either under the bona fide residence test or under the physical presence test. The above test applies to US resident aliens if the resident alien is the citizen of a country with which the United States has a tax treaty. The number of days being present in a foreign country or foreign country is not the only criterion under the US tax system to be treated as a bona fide resident of a foreign country, your intention and the nature of your stays are also important that IRS may look into.
Physical presence test
To meet the physical presence test as per the US tax system, a US citizen or resident alien needs to be present for 330 full days in a foreign country or foreign countries. IRS considers the 24 hour period which starts from zero am to midnight. In this scenario, your stay in a foreign country or foreign countries need not be uninterrupted. However, as mentioned above any day that you were present in the United States will not be counted as your foreign stay.
You may also be entitled to the waiver of the above time limit in certain situations, including reasons related to the COVID-19 emergency.
You can claim foreign earned income exclusion for your wages, salaries, professional fees, and other compensations received for personal services rendered in a foreign country.
Foreign earned income
Under the US tax system foreign earned is the income that you received or earned in a foreign country or countries in a tax year by rendering services in a foreign country or country. The types of income that are included are salaries and wages, professional fees, and other compensation or allowances for personal services rendered in a foreign country or country. Your foreign income will also include any benefits given to you cash or in kind, for example, a home or car. You have the option to report your income in tax year either as per the accrual method or as per the cash method.
Foreign earned income does not include:
– Corporate distribution
– Business income
– Rental income
– Interest, dividends, capital gains, etc.
– Pension and annuity income
If you are self-employed in a business or trade where the income produced by the business involves your personal services as well as the capital employed, a reasonable amount of that income can be considered as earned income for your personal services. However, this amount is limited to 30% of your total net profit from your business after deducting the deduction for the employer-equivalent portion of self-employment tax.
Once you choose to claim either of the exclusions or the housing deduction, you may not be entitled to the following credits and/or special rules may apply:
– Additional child tax credits
– Earned income credit
– Foreign tax credit
– IRA deduction
You can claim a reasonable portion of your foreign housing expenses. Reasonable housing expenses are considered to the extent they are not lavish or exaggerated under the circumstances. Housing expenses include rent, utilities, real and personal property insurance, repairs and maintenance, and mortgage interest. You can only deduct your housing expenses if you meet the tax home test and either the bona fide residence test or physical presence test.
You may also be entitled to claim expenses related to your second foreign household if you maintained the second foreign house for your spouse and dependents in addition to your tax home. The second foreign house will only qualify if you maintained this second house due to dangerous, unhealthful, or other adverse conditions.
The above information has been presented in a summarized form. You may need to contact your accountant for further information before considering the information’s applicability to your particular situation.
RKB Accounting has expertise in cross-border taxation and has been providing accounting and taxation services for the last fifteen years in Canada and USA. RKB services include incorporating a business on both sides of the border, bookkeeping, sales tax, payroll, and corporate and personal income tax. RKB’s expertise includes cross-border tax planning, long-term tax planning, helping business start-ups, business structure planning, and resolving complex tax matters. RKB a CPA(Delaware), CA(India), and CIA(USA) has over 25 years of experience in accounting and taxation in dealing with various countries in the world.
Disclaimer: Information in the blog/post/article has been presented for a broad and simple understanding. This is not legal advice. RKB Accounting & Tax Services does not accept any liability for its application in any real situations. You need to contact your accountant or us for further information.