What is the Foreign Earned Income Exclusion (Form 2555)?

If you earn money while you are living in a foreign country, you must still pay U.S. federal taxes. In some cases, though, you may be eligible to exclude some or all of your foreign income from the taxable income you must report on your U.S. tax return.

The amount of income you can exclude is inflation-adjusted each year. You may also be eligible to take a deduction for the costs of housing in a foreign country and/or exclude some of the costs you spend for foreign housing.

To qualify for the foreign earned income exclusion one of the following statements must be true:

Before taking the foreign earned income exclusion, you must meet certain tests to confirm that you are eligible based on the statements above:

In limited exceptions, you may be able to claim the foreign earned income exclusion even if you do not meet one of the tests.

The IRS provides an interactive tool to help you determine whether you qualify to take the foreign income exclusion.

If you qualify, you must file Form 2555, Foreign Earned Income with your federal tax return. The Instructions for Form 2555 contain detailed information and worksheets to help you figure out the amount of foreign earned income you can exclude as well as the amount of the foreign housing exclusion and foreign housing deduction you qualify for, if any. 

Important: U.S. taxpayers who work abroad as employees of the U.S. Government are not eligible to take the foreign income exclusion, the foreign housing exclusion or the foreign housing deduction.

Who can claim the foreign tax credit (Form 1116)?

Working in a foreign country can be fun and interesting, as well as challenging, but the prospect of double taxation probably isn’t nearly as appealing as seeing the world. The Foreign Tax Credit is a nonrefundable credit that can reduce the amount of U.S. income taxes you pay if you have also paid taxes to the country where you earned the income.

Not all foreign taxes qualify for treatment under the rules for claiming the foreign tax credit. To qualify, the taxes must meet the following four tests, per IRS Topic No. 856, Foreign Tax Credit:

The IRS offers a detailed discussion of the qualifying tests and a list of Foreign Taxes that Qualify for the Foreign Tax Credit, together with a list of foreign taxes that do not qualify for the credit.

Unlike most federal tax benefits, the foreign tax credit can be claimed in the form of a credit or a deduction. To claim it as a credit you must file Form 1116, Foreign Tax Credit. If you wish to claim the foreign tax credit in the form of a deduction, you must itemize deductions and report the qualified foreign taxes you paid on Schedule A, Itemized Deductions.

Generally speaking, taking this tax benefit as a credit will offer you the greatest reduction in your tax liability, but this is not true in every situation.

Important: If you claim a foreign income exclusion then you must reduce the amount of foreign taxes you claim for the foreign tax credit. The foreign tax credit is a complicated tax benefit, albeit a valuable one. Before claiming any benefits based on foreign taxes you paid, you may wish to review the following IRS resources:

Note: In certain situations, individual taxpayers may be able to claim the foreign tax credit without filing Form 1116. Estates and trusts must always include Form 1116 when claiming the foreign tax credit. Corporations must claim it using Form 1118 rather than Form 1116.

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