TAXES > Individuals > Adjustments > Foreign Earned Income Exclusion (Form 2555)

Foreign Income of U.S. Taxpayers

U.S. taxpayers - U.S. citizens, U.S. residents, U.S. (domestic) corporations and other taxable U.S. entities - ordinarily are fully taxable on their income from outside the U.S., subject to special exemptions and other special treatment for particular taxpayers, and particular kinds and sources of income. Nonresident aliens, foreign corporations and other foreign entities, however, are taxed only on their income that is effectively connected with a U.S. trade or business, and certain passive income derived from U.S. sources. Nonresidents who gave up U.S. citizenship or terminated long-term U.S. residency are subject to special expatriation tax rules. U.S. citizens, whether they reside in the U.S. or abroad, are generally subject to U.S. income tax on their income from sources outside the U.S. with exemptions for foreign earned income and housing costs, income from U.S. possessions, and certain allowances for U.S. government employees.

Every person born or naturalized in the U.S. and subject to its jurisdiction is a U.S. citizen. A foreigner who has filed a declaration of intent to become a citizen but who hasn't yet been admitted to citizenship by a final order of a naturalization court is an alien. For any tax year in which an individual "qualifies," he may elect to exclude from gross income foreign earned income of up to $72,000 for 1998 (gradually increasing to $80,000 for 2002 and thereafter) of foreign earned income. Individuals employed in high-tax countries generally get no benefit from the exclusion; if they reported their foreign earned income and claimed credit for the foreign tax paid, the credit would fully offset their U.S. tax on the income. An individual's "foreign earned income" is his earned income from foreign sources attributable to services he performed during the period he "qualifies." Earned income is wages and other amounts received as compensation (i.e., not as a distribution of profits) for personal services actually rendered. This includes cash, the fair market value of property, and allowances or reimbursements (including taxable moving expense reimbursements) attributable to performing those services and, where both personal services and capital are material income-producing factors in the taxpayer's noncorporate business, a reasonable allowance (up to 30% of his share of the net profits) as compensation for personal services. "Foreign earned income" doesn't include pensions or annuities, or certain amounts paid by the U.S. or a federal agency to its employees. An individual's foreign earned income exclusion for a tax year cannot exceed his foreign earned income for the year, as computed on a daily basis at an annual rate of $72,000 for 1998, $74,000 for 1999, $76,000 for 2000, $78,000 for 2001, and $80,000 for 2002 and thereafter (indexed for inflation for post-2007 years). If the individual also elects the foreign housing costs exclusion, his foreign earned income exclusion is the lesser of: (a) $72,000 for 1998, $74,000 for 1999, etc., multiplied by the number of days in the tax year on which he "qualified," and divided by the number of days in the year, or (b) his foreign earned income as reduced by the foreign housing costs exclusion for the year. For married couples, the exclusion (and ceiling) is computed separately for each spouse based on the income attributable to the spouse's services. If the spouses file separate returns, each may exclude the amount of his foreign earned income attributable to his services, subject to the ceilings. If the spouses file a joint return, the sum of those separate amounts may be excluded.

A qualified individual may elect to exclude from gross income a part of his housing costs paid or incurred as a result of his foreign employment. A qualified individual who elects the housing costs exclusion may not claim less than the full amount of the allowable exclusion. The amount of housing costs eligible for exclusion in a tax year is the excess of (1) the individual's housing expenses for the year, over (2) 16% of the salary (computed on a daily basis) of a U.S. employee compensated at a rate equal to the annual rate paid for step 1 of grade GS-14 (the specific amount is built into each year's Form 2555 calculation of the exclusion), multiplied by the number of days in the tax year within the individual's period of foreign residence or presence. Where spouses reside together and both claim a foreign housing costs exclusion (or deduction), they may compute their exclusion separately or jointly. Spouses who file separate returns must make separate computations, but they may allocate the housing expenses between them. Where spouses reside apart, they both may exclude (or deduct) their respective housing cost amounts if their tax homes are not within reasonable commuting distance of each other and neither spouse's residence is within a reasonable commuting distance of the other spouse's tax home. If the spouses' tax homes or residences are within reasonable commuting distance, only one spouse may exclude (or deduct) his housing cost amount. In either case, and whether they file separately or jointly, the amount of the housing costs exclusion (or deduction) is determined separately for each spouse. Also, only housing expenses for the abode bearing the closest relationship to the taxpayer's tax home, or to a second foreign household for his spouse and dependents who do not reside with him because of adverse living conditions, qualify for the exclusion.

A qualified individual with foreign housing expenses that are not attributable to employer-provided amounts may deduct those expenses. The deduction is limited to the individual's foreign earned income for the tax year which is not otherwise excluded from gross income under either the foreign earned income or foreign housing costs exclusions. Any unused housing expenses may be carried over and deducted in the next tax year, subject to that year's limits. The sum of an individual's foreign earned income exclusion and foreign housing costs exclusion and/or deduction for any tax year cannot exceed his foreign earned income for the year. A taxpayer "qualifies" for the foreign earned income and housing costs exclusions for a tax year if his "tax home" (below) is in a foreign country and he is either (1) a U.S. citizen who meets a foreign residence test. To meet this test, the individual must be a bona fide resident of one or more foreign countries for an uninterrupted period including an entire tax year. A resident alien who is a national of a "treaty" country may qualify, or (2) a U.S. citizen or resident who meets a foreign presence test. To meet this test, the individual must, in any period of 12 consecutive months, be present in one or more foreign countries during at least 330 full days. This means physically present, including time while on vacation or unemployed. For married couples, if both spouses "qualify," each may elect the exclusions or deduction.

An individual's "tax home" is his home for purposes of deducting away-from-home travel expenses. He has no "tax home" in a foreign country for any period his abode is in the U.S. But the fact that an individual is temporarily present in the U.S. or maintains a U.S. dwelling (even if used by his spouse or dependents) does not necessarily mean his abode is in the U.S. The foreign presence or residence time requirements may be waived by IRS if it determines that local unrest (war, civil disturbance, etc.) precludes the normal conduct of business, but only for taxpayers already present in, or bona fide residents of, the foreign country. These countries are Afghanistan, Albania, Bosnia and Herzegovina, Cambodia, Central African Republic, Croatia, Democratic Republic of the Congo, Iran, Lebanon, Macedonia, Montenegro, Republic of the Congo, Serbia, Sierra Leone, Somalia, and Tajikstan.

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