3.   Exclusions From Gross Income

Table of Contents

Introduction

Resident and nonresident aliens are allowed exclusions from gross income if they meet certain conditions. An exclusion from gross income is generally income you receive that is not included in your U.S. income and is not subject to U.S. tax. This chapter covers some of the more common exclusions allowed to resident and nonresident aliens.

Topics - This chapter discusses:

  • Nontaxable interest,

  • Nontaxable dividends,

  • Certain compensation paid by a foreign employer,

  • Gain from sale of home, and

  • Scholarships and fellowship grants.

Useful Items - You may want to see:

Publication

  • 54 Tax Guide for U.S. Citizens and Resident Aliens Abroad

  • 523 Selling Your Home

See chapter 12 for information about getting these publications.

Resident Aliens

Resident aliens may be able to exclude the following items from their gross income.

Foreign Earned Income and Housing Amount

If you are physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months, you may qualify for the foreign earned income exclusion. The exclusion is $95,100 in 2012. In addition, you may be able to exclude or deduct certain foreign housing amounts. You may also qualify if you are a bona fide resident of a foreign country and you are a citizen or national of a country with which the United States has an income tax treaty. For more information, see Publication 54.

Foreign country.    A foreign country is any territory under the sovereignty of a government other than that of the United States.

  The term “foreign country” includes the country's territorial waters and airspace, but not international waters and the airspace above them. It also includes the seabed and subsoil of those submarine areas adjacent to the country's territorial waters over which it has exclusive rights under international law to explore and exploit the natural resources.

  The term “foreign country” does not include U.S. possessions or territories. It does not include the Antarctic region.

Nonresident Aliens

Nonresident aliens can exclude the following items from their gross income.

Interest Income

Interest income that is not connected with a U.S. trade or business is excluded from income if it is from:

  • Deposits (including certificates of deposit) with persons in the banking business,

  • Deposits or withdrawable accounts with mutual savings banks, cooperative banks, credit unions, domestic building and loan associations, and other savings institutions chartered and supervised as savings and loan or similar associations under federal or state law (if the interest paid or credited can be deducted by the association), and

  • Amounts held by an insurance company under an agreement to pay interest on them.

State and local government obligations.   Interest on obligations of a state or political subdivision, the District of Columbia, or a U.S. possession, generally is not included in income. However, interest on certain private activity bonds, arbitrage bonds, and certain bonds not in registered form is included in income.

Portfolio interest.   Interest and original issue discount that qualifies as portfolio interest is not subject to NRA withholding. To qualify as portfolio interest, the interest must be paid on obligations issued after July 18, 1984, and otherwise subject to NRA withholding.

Note.

The rules for determining whether interest is portfolio interest have changed for obligations issued after March 18, 2012. Before March 19, 2012, portfolio interest included interest on certain registered and nonregistered (bearer) bonds if the obligations meet the requirements described below.

For obligations issued after March 18, 2012, portfolio interest does not include interest paid on debt that is not in registered form.

Obligations in registered form.   Portfolio interest includes interest paid on an obligation that is in registered form, and for which you have received documentation that the beneficial owner of the obligation is not a United States person.

  Generally, an obligation is in registered form if: (i) the obligation is registered as to both principal and any stated interest with the issuer (or its agent) and any transfer of the obligation may be effected only by surrender of the old obligation and reissuance to the new holder; (ii) the right to principal and stated interest with respect to the obligation may be transferred only through a book entry system maintained by the issuer or its agent; or (iii) the obligation is registered as to both principal and stated interest with the issuer or its agent and can be transferred both by surrender and reissuance and through a book entry system.

  An obligation that would otherwise be considered to be in registered form is not considered to be in registered form as of a particular time if it can be converted at any time in the future into an obligation that is not in registered form. For more information on whether obligations are considered to be in registered form, see Portfolio interest in Publication 515.

Obligations not in registered form.    For obligations issued before March 19, 2012, interest on an obligation that is not in registered form (bearer obligation) is portfolio interest if the obligation is foreign-targeted. A bearer obligation is foreign-targeted if:

  • There are arrangements to ensure that the obligation will be sold, or resold in connection with the original issue, only to a person who is not a United States person,

  • Interest on the obligation is payable only outside the United States and its possessions, and

  • The face of the obligation contains a statement that any United States person who holds the obligation will be subject to limits under the United States income tax laws.

  Documentation is not required for interest on bearer obligations to qualify as portfolio interest. In some cases, however, you may need documentation for purposes of Form 1099 reporting and backup withholding.

Interest that does not qualify as portfolio interest.   Payments to certain persons and payments of contingent interest do not qualify as portfolio interest. You must withhold at the statutory rate on such payments unless some other exception, such as a treaty provision, applies.

Contingent interest.   Portfolio interest does not include contingent interest. Contingent interest is either of the following:

  1. Interest that is determined by reference to:

    1. Any receipts, sales, or other cash flow of the debtor or related person,

    2. Income or profits of the debtor or related person,

    3. Any change in value of any property of the debtor or a related person, or

    4. Any dividend, partnership distributions, or similar payments made by the debtor or a related person.

    For exceptions, see Internal Revenue Code section 871(h)(4)(C).

  2. Any other type of contingent interest that is identified by the Secretary of the Treasury in regulations.

Related persons.   Related persons include the following.

  • Members of a family, including only brothers, sisters, half-brothers, half-sisters, spouse, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).

  • Any person who is a party to any arrangement undertaken for the purpose of avoiding the contingent interest rules.

  • Certain corporations, partnerships, and other entities. For details, see Nondeductible Loss in chapter 2 of Publication 544.

Exception for existing debt.   Contingent interest does not include interest paid or accrued on any debt with a fixed term that was issued:

  • On or before April 7, 1993, or

  • After April 7, 1993, pursuant to a written binding contract in effect on that date and at all times thereafter before that debt was issued.

Dividend Income

The following dividend income is exempt from the 30% tax.

Certain dividends paid by foreign corporations.   There is no 30% tax on U.S. source dividends you receive from a foreign corporation. See Second exception under Dividends in chapter 2 for how to figure the amount of U.S. source dividends.

Certain interest-related dividends.   There is no 30% tax on interest-related dividends from sources within the United States that you receive from a mutual fund or other regulated investment company in 2012. The mutual fund will designate in writing which dividends are interest-related dividends.

Certain short-term capital gain dividends.   There may not be any 30% tax on certain short-term capital gain dividends from sources within the United States that you receive from a mutual fund or other regulated investment company. The mutual fund will designate in writing which dividends are short-term capital gain dividends. This tax relief will not apply to you if you are present in the United States for 183 days or more during your tax year.

Services Performed for Foreign Employer

If you were paid by a foreign employer, your U.S. source income may be exempt from U.S. tax, but only if you meet one of the situations discussed next.

Employees of foreign persons, organizations, or offices.   Income for personal services performed in the United States as a nonresident alien is not considered to be from U.S. sources and is tax exempt if you meet all three of the following conditions.

  1. You perform personal services as an employee of or under a contract with a nonresident alien individual, foreign partnership, or foreign corporation, not engaged in a trade or business in the United States; or you work for an office or place of business maintained in a foreign country or possession of the United States by a U.S. corporation, a U.S. partnership, or a U.S. citizen or resident.

  2. You perform these services while you are a nonresident alien temporarily present in the United States for a period or periods of not more than a total of 90 days during the tax year.

  3. Your pay for these services is not more than $3,000.

If you do not meet all three conditions, your income from personal services performed in the United States is U.S. source income and is taxed according to the rules in chapter 4.

  If your pay for these services is more than $3,000, the entire amount is income from a trade or business within the United States. To find if your pay is more than $3,000, do not include any amounts you get from your employer for advances or reimbursements of business travel expenses, if you were required to and did account to your employer for those expenses. If the advances or reimbursements are more than your expenses, include the excess in your pay for these services.

  A day means a calendar day during any part of which you are physically present in the United States.

Example 1.

During 2012, Henry Smythe, a nonresident alien from a nontreaty country, worked for an overseas office of a U.S. partnership. Henry, who uses the calendar year as his tax year, was temporarily present in the United States for 60 days during 2012 performing personal services for the overseas office of the partnership. That office paid him a total gross salary of $2,800 for those services. During 2012, he was not engaged in a trade or business in the United States. The salary is not considered U.S. source income and is exempt from U.S. tax.

Example 2.

The facts are the same as in Example 1, except that Henry's total gross salary for the services performed in the United States during 2012 was $4,500. He received $2,875 in 2012, and $1,625 in 2013. During 2012, he was engaged in a trade or business in the United States because the compensation for his personal services in the United States was more than $3,000. Henry's salary is U.S. source income and is taxed under the rules in chapter 4.

Crew members.   Compensation for services performed by a nonresident alien in connection with the individual's temporary presence in the United States as a regular crew member of a foreign vessel (for example, a boat or ship) engaged in transportation between the United States and a foreign country or U.S. possession is not U.S. source income and is exempt from U.S. tax. This exemption does not apply to compensation for services performed on foreign aircraft.

Students and exchange visitors.   Nonresident alien students and exchange visitors present in the United States under “F,” “J,” or “Q” visas can exclude from gross income pay received from a foreign employer.

  This group includes bona fide students, scholars, trainees, teachers, professors, research assistants, specialists, or leaders in a field of specialized knowledge or skill, or persons of similar description. It also includes the alien's spouse and minor children if they come with the alien or come later to join the alien.

  A nonresident alien temporarily present in the United States under a “J” visa includes an alien individual entering the United States as an exchange visitor under the Mutual Educational and Cultural Exchange Act of 1961.

Foreign employer.   A foreign employer is:

  • A nonresident alien individual, foreign partnership, or foreign corporation, or

  • An office or place of business maintained in a foreign country or in a U.S. possession by a U.S. corporation, a U.S. partnership, or an individual who is a U.S. citizen or resident.

  The term “foreign employer” does not include a foreign government. Pay from a foreign government that is exempt from U.S. income tax is discussed in chapter 10.

Income from certain annuities.   Do not include in income any annuity received under a qualified annuity plan or from a qualified trust exempt from U.S. income tax if you meet both of the following conditions.

  1. You receive the annuity only because:

    1. You performed personal services outside the United States while you were a nonresident alien, or

    2. You performed personal services inside the United States while you were a nonresident alien and you met the three conditions, described earlier, under Employees of foreign persons, organizations, or offices .

  2. At the time the first amount is paid as an annuity under the plan (or by the trust), 90% or more of the employees for whom contributions or benefits are provided under the annuity plan (or under the plan of which the trust is a part) are U.S. citizens or residents.

  If the annuity qualifies under condition (1) but not condition (2) above, you do not have to include the amount in income if:

  • You are a resident of a country that gives a substantially equal exclusion to U.S. citizens and residents, or

  • You are a resident of a beneficiary developing country under Title V of the Trade Act of 1974.

  If you are not sure whether the annuity is from a qualified annuity plan or qualified trust, ask the person who made the payment.

Income affected by treaties.   Income of any kind that is exempt from U.S. tax under a treaty to which the United States is a party is excluded from your gross income. Income on which the tax is only limited by treaty, however, is included in gross income. See chapter 9.

Gambling Winnings From Dog or Horse Racing

You can exclude from your gross income winnings from legal wagers initiated outside the United States in a parimutuel pool with respect to a live horse or dog race in the United States.

Gain From the Sale of Your Main Home

If you sold your main home, you may be able to exclude up to $250,000 of the gain on the sale of your home. If you are married and file a joint return, you may be able to exclude up to $500,000. For information on the requirements for this exclusion, see Publication 523.

This exclusion does not apply to nonresident aliens who are subject to the expatriation tax rules discussed in chapter 4.

Scholarships and Fellowship Grants

If you are a candidate for a degree, you may be able to exclude from your income part or all of the amounts you receive as a qualified scholarship. The rules discussed here apply to both resident and nonresident aliens.

If a nonresident alien receives a grant that is not from U.S. sources, it is not subject to U.S. tax. See Scholarships, Grants, Prizes, and Awards in chapter 2 to determine whether your grant is from U.S. sources.

A scholarship or fellowship is excludable from income only if:

  1. You are a candidate for a degree at an eligible educational institution, and

  2. You use the scholarship or fellowship to pay qualified education expenses.

Candidate for a degree.   You are a candidate for a degree if you:

  1. Attend a primary or secondary school or are pursuing a degree at a college or university, or

  2. Attend an accredited educational institution that is authorized to provide:

    1. A program that is acceptable for full credit toward a bachelor's or higher degree, or

    2. A program of training to prepare students for gainful employment in a recognized occupation.

Eligible educational institution.   An eligible educational institution is one that maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where it carries on its educational activities.

Qualified education expenses.   These are expenses for:

  • Tuition and fees required to enroll at or attend an eligible educational institution, and

  • Course-related expenses, such as fees, books, supplies, and equipment that are required for the courses at the eligible educational institution. These items must be required of all students in your course of instruction.

However, in order for these to be qualified education expenses, the terms of the scholarship or fellowship cannot require that it be used for other purposes, such as room and board, or specify that it cannot be used for tuition or course-related expenses.

Expenses that do not qualify.   Qualified education expenses do not include the cost of:

  • Room and board,

  • Travel,

  • Research,

  • Clerical help, or

  • Equipment and other expenses that are not required for enrollment in or attendance at an eligible educational institution.

This is true even if the fee must be paid to the institution as a condition of enrollment or attendance. Scholarship or fellowship amounts used to pay these costs are taxable.

Amounts used to pay expenses that do not qualify.   A scholarship amount used to pay any expense that does not qualify is taxable, even if the expense is a fee that must be paid to the institution as a condition of enrollment or attendance.

Payment for services.   You cannot exclude from income the portion of any scholarship, fellowship, or tuition reduction that represents payment for past, present, or future teaching, research, or other services. This is true even if all candidates for a degree are required to perform the services as a condition for receiving the degree.

Example.

On January 7, Maria Gomez is notified of a scholarship of $2,500 for the spring semester. As a condition for receiving the scholarship, Maria must serve as a part-time teaching assistant. Of the $2,500 scholarship, $1,000 represents payment for her services. Assuming that Maria meets all other conditions, she can exclude no more than $1,500 from income as a qualified scholarship.

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