Under IRC §911, taxpayers working outside the U.S. ("expatriates") may benefit from electing the Foreign Earned Income Exclusion (FEIE) and the Foreign Housing Exclusion (FHE) if certain qualifying tests are met. In order for these elections to be available, the expatriate must:
-Establish that there is a foreign “tax home” and
-Meet either the bona fide residence test or the physical presence test with respect to their foreign residency
Tax Home
Generally, a taxpayer’s tax home is considered to be the regular or principal place of business, (or the taxpayer’s regular place of abode in a real and substantial sense in the absence of a regular or principal place of business). Most expatriates that take up legitimate residence in a foreign country for a long-term foreign work assignment have no difficulty meeting the foreign tax home requirement.
Bona Fide Residence Test
This test is met when a U.S. citizen establishes a bona fide foreign residence for a period that includes an entire calendar year period (meaning January 1 through December 31). Accordingly, if the expatriate moves to the foreign country to begin a long term work assignment on January 28, 2015, the bona fide residence test would not be met until the end of December 31, 2016 (to include the full 2016 calendar year). However, once the bona fide residence test is met, it applies retroactively. In addition, an expatriate who has not met the bona fide residence test as of their filing due date may obtain a special extension of time to file the return so that the return may be filed after the expatriate qualifies. The extension is generally granted to 30 days after the date the expatriate is reasonably expected to qualify. Temporary returns to the U.S. after the establishment of a foreign bona fide residence do not generally affect the expatriate’s ability to qualify. However, the bona fide residence test is not met if the expatriate either:
-Makes a statement to authorities of the foreign country that he or she is not a resident of that country, or
-Is not subject to income taxation in the foreign country because of nonresident status in that foreign country.
In addition, the expatriate must generally be a U.S. citizen to meet the bona fide residence test. However, resident aliens of the U.S. may meet the bona fide residence test for FEIE and FHA exclusion purposes if the U.S. has a tax treaty with their home country with an applicable non-discrimination clause.
Physical Presence Test
An expatriate (whether a U.S. citizen or resident alien) can meet this test if they are physically present in one or more foreign countries for at least 330 days within any 12 month period. In addition, the required 330 day period need not be continuous. While the physical presence test is easy to apply to the client’s situation, it is only one reason why expatriate clients should be advised to maintain accurate, well-documented records of the number of days in the U.S. and outside the U.S., including travel days.
Foreign Earned Income Exclusion (FEIE)
Generally, the FEIE allows a qualifying expatriate to exclude “foreign earned income” up to the lesser of $101,300 (for 2016) and the amount of foreign earned income for the year. The $101,300 amount is subject to an annual inflation adjustment. Foreign earned income includes wages, salaries, professional fees and other compensation received for personal services actually rendered when the expatriate had a foreign tax home while meeting the bona fide residence test or physical presence test. It must be earned income attributable to the expatriate’s services in a foreign country.
Certain itemized deductions may be disallowed if the expatriate elects to claim the FEIE because of rules designed to prevent a “double benefit” to claiming the FEIE. The deductions related to foreign income are not allowed to the extent they are attributable to the amount of foreign income being excluded due to the election of the FEIE.
In addition, for situations in which the expatriate has a mix of U.S. income and foreign earned income, it is necessary to allocate the total income to determine the foreign earned income component. This allocation is typically accomplished using the number of days spent inside and outside the U.S. (again underscoring the expatriate’s need to keep a detailed log of their days spent within and outside the U.S., including travel days, so that the particular allocation calculation can be documented.
Foreign Housing Exclusion
The expatriate may also elect to exclude from U.S. income an additional amount for eligible foreign housing expenses. Eligible expenses include reasonable expenses for items such as rental payments, utilities (with the exception of telephone costs), insurance costs for real and personal property, nonrefundable fees paid to obtain a lease, furniture rental, residential parking fees and any repairs to the household. Lavish or extravagant expenses may not be included, and this exclusion only applies to qualifying amounts paid by the expatriate or taxable amounts paid on behalf of the expatriate by the employer (without regard to any FEIE claim). Meal or lodging costs that are claimed as moving expenses or excluded from gross income under other rules may not be claimed under the FHE.
Generally, the excludible amount of income attributable to these eligible expenses under the FHE is calculated using a “ceiling” maximum (30% of the maximum FEIE amount of $101,300 for 2016) less a “floor” amount of 16% of that maximum FEIE amount. The result is a maximum FHE amount that is 14% (30% - 16%) of $101,300, or $14,182 for 2016. The ceiling amount for some expatriates, however, may be adjusted upward if they are living in an area the IRS considers to be a high living expense area that warrants a higher exclusion for housing costs. These higher cost areas and respective ceiling amounts are found in IRS Notice 2016-21.
The expatriate may elect either or both of these special exclusions from income for U.S. tax purposes. There are situations in which the expatriate employee may not wish to make the election. Perhaps this most frequently occurs if the expatriate is working in a high tax rate jurisdiction. Under such circumstances, it may be best to include all of the foreign income for U.S. purposes, because the expatriate will benefit from a Foreign Tax Credit (discussed in the next section) based on the foreign taxes paid attributable to all the foreign income (and not just on the income included on the U.S. return after the FEIE has been claimed). I've recently completed returns for a client working in India that we found to be in this very circumstance. Typically, comparative tax calculations will indicate if it is optimal for the expatriate to claim either the FEIE or FHE, both of them, or neither.