Navigating the Intricacies of the Foreign Earned Income Exclusion (FEIE)

The Foreign Earned Income Exclusion (FEIE) is a provision in the United States tax code that allows qualifying US citizens and resident aliens living and working abroad to exclude a certain amount of their foreign-earned income from US taxation. The exclusion aims to prevent double taxation for individuals who earn income both in the U.S. and in a foreign country.

As such, it’s suitable for expats and digital nomads, albeit not being the only option out there.  

Who Qualifies for Foreign Earned Income Exclusion?

To qualify for the Foreign Earned Income Exclusion, an individual must meet one of two tests: the Physical Presence Test or the Bona Fide Residence Test.

The former requires individuals to be physically present in a foreign country for at least 330 full days during any consecutive twelve-month period.

The latter necessitates the individual to establish a bona fide residence in a foreign country, indicating a true and permanent home abroad.

Alternatively, the Bona Fide Residence Test requires individuals to establish a long-term residence in a foreign country, indicating an intention to make the foreign country their home. It's critical to understand that simply owning property or having a temporary work assignment abroad may not be sufficient to pass the tests. The IRS assesses each case individually, considering various factors to determine whether an individual's circumstances meet the criteria.

What Does FEIE Exclude?

The excluded income under the FEIE covers wages, salaries, professional fees, and other compensation received for personal services performed in a foreign country. However, note that not all types of income are eligible for exclusion, and certain limitations apply. Passive income (e.g.,  dividends, interest, and rental income) generally does not qualify for the exclusion.

To claim the FEIE, eligible individuals should file Form 2555 or Form 2555-EZ along with their annual US income tax return. Both of these forms detail information about foreign income, the length of stay abroad, and qualifications under either the Physical Presence Test or the Bona Fide Residence Test.

Meeting the Requirements of the Physical Presence Test

To pass the Physical Presence Test, the applicant must be physically present within the borders of a foreign country for 330 days. This includes any time spent on vacation, business trips, or other temporary absences. The count begins on the first day an individual sets foot in the foreign country and concludes on the 330th day (it doesn’t necessarily align with the calendar year).

Note, however, that partial days do not count: each day must be a full 24 hours spent within the foreign country.

To be able to pass the test, the individual should maintain accurate records of travel and stays in foreign countries. A detailed calendar/ travel log that includes entry and exit dates and any supporting documents necessary (e.g., boarding passes and passport stamps) can help applicants navigate FEIE requirements more efficiently.

Meeting the Requirements of the Bona Fide Residence Test

The Bona Fide Residence Test is a key qualification for US expats seeking the benefits of the FEIE. Unlike the Physical Presence Test (which focuses on the duration of physical presence in a foreign country), the Bona Fide Residence Test revolves around the applicant establishing a long-term residence in a foreign country.

To meet the criteria of the Bona Fide Residence Test, the applicant must demonstrate a substantial connection to the foreign country, showcasing a permanent presence. This goes beyond mere physical presence and involves factors such as the establishment of a home, family ties, community involvement, and overall integration into the local culture.

The practice signifies a commitment to a foreign country as the primary place of employment. Factors such as the location of employment, business activities, and the center of vital economic interests contribute to the determination of a tax home. This is a critical aspect of the Bona Fide Residence Test, distinguishing it from temporary work assignments or short-term stays that may not qualify for the exclusion.

What Can and Cannot Be Exempted?

If you are a U.S. citizen or a resident alien of the United States and you live abroad, you are taxed on your worldwide income. However, you may qualify to exclude your foreign earnings from income up to an amount that is adjusted annually for inflation ($107,600 for 2020, $108,700 for 2021, $112,000 for 2022, and $120,000 for 2023). In addition, you can exclude or deduct certain foreign housing amounts.

Source: IRS

U.S. expats may exclude a portion of their foreign-earned income from U.S. taxation, as follows:

Income eligible for exclusion:

1. Wages and salaries
2. Self-employment income
3. Housing allowances

Income not eligible for exclusion:

1. Passive Income (dividends, interest, capital gains, rental income, etc.)
2. Employer-provided non-cash benefits

If foreign-earned income exceeds the FEIE limits, the excess amount is subject to regular U.S. income tax.

Overall, maintaining a detailed report is crucial in this matter, so stay vigilant and seek professional help if you’re a novice expat.