A common misconception about the foreign earned income exclusion is that the excluded income does not need to be reported on a U.S. tax return. In fact, the exclusion applies only if you are a qualifying individual with foreign earned income who meets all of the requirements to claim the foreign earned income exclusion and you file a tax return reporting the income.
Limit on Excludable Amount
The maximum foreign earned income exclusion amount is adjusted annually for inflation. For tax year 2019, the maximum foreign earned income exclusion is the lesser of the foreign income earned or $105,900 per qualifying person. For tax year 2020, the maximum exclusion is $107,600 per person. If two individuals are married, and both work abroad and meet either the bona fide residence test or the physical presence test, each one can choose the foreign earned income exclusion. Together, they can exclude as much as $215,200 for the 2020 tax year.
If the period for which you qualify for the foreign earned income exclusion includes only part of the year, you must adjust the maximum limit based on the number of qualifying days in the year, as discussed below.
In addition, the amount of qualified housing expenses eligible for the foreign housing exclusion or housing deduction is also limited. The limitation on housing expenses is generally 30% of the maximum foreign earned income exclusion. For 2019, the housing amount limitation is $31,770. However, the limit will vary depending upon the location of your foreign tax home and the number of qualifying days in the tax year.
If you are claiming a foreign housing exclusion, you must figure that amount first because the foreign earned income exclusion is limited to your foreign earned income minus any foreign housing exclusion you claim.
Amounts Paid in Year Following Work
Generally, you are considered to have earned income in the year in which you do the work for which you receive the income, even if you work in one year but are not paid until the following year. This can affect how much income you can exclude in the year in which you earn it, even if you aren’t paid until the following year. Additionally, if you report your income on a cash basis, you still must report the income on your return for the year you receive it. Brief discussions of some of the common timing issues are discussed below; for further information, see Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
Amount Received in the Year After It Was Earned
Regardless of when you receive income, you must apply it to the year in which you earned it to determine your excludable amount for that year. For example, a bonus may be based on work you did over several years. You determine the amount of the bonus that is considered earned in a particular year in two steps.
- Divide the bonus by the number of calendar months in the period when you did the work that resulted in the bonus.
- Multiply the result by the number of months you did the work during the year. This is the amount that is subject to the exclusion limit for that tax year.
You were a bona fide resident of a foreign country for all of 2018 and 2019. You report your income on the cash basis. In 2018, you were paid $90,000 for work you did in the foreign country during that year. You excluded all the $90,000 from your income for 2018. In 2019, you received $20,000 for work you did in 2018. You can exclude $13,900 of the $18,800 from your income in 2019. This is the $103,900 maximum foreign earned income exclusion for 2018 minus the $90,000 you already excluded for that year. You must include the remaining $6,100 in income for 2019 ($20,000 - $13,900) because you could not have excluded that income in 2018 if you had received it that year.
CAUTION! You cannot exclude income you receive after the end of the year following the year in which you did the work to earn it.
You qualified as a bona fide resident of a foreign country for 2017, 2018, and 2019. You report your income on the cash basis. In 2017, you were paid $70,000 for work you did in the foreign country that year and in 2018 you were paid $80,000 for that year's work in the foreign country. You excluded all that income on your 2017 and 2018 returns.
In 2019, you were paid $100,000; $90,000 for your work in the foreign country during 2019, and $10,000 for work you did there in 2017. You must include the $10,000 in income. Of the $100,000 you received in 2019, you can exclude the $90,000 received for work you did in 2019. You cannot exclude any of the $10,000 for work done in 2017 because you received it after the end of the year following the year in which you earned it.
Year-End Payroll Period
There is an exception to the general rule that income is considered earned in the year you do the work for which you receive the income. If you are a cash-basis taxpayer, any salary or wage payment you receive after the end of the year in which you do the work for which you receive the pay is considered earned entirely in the year you receive it if all four of the following apply.
The period for which the payment is made is a normal payroll period of your employer that regularly applies to you.
The payroll period includes the last day of your tax year (December 31 if you figure your taxes on a calendar-year basis).
- The payroll period is no longer than 16 days.
- The payday falls at the same time in relation to the payroll period that it normally would fall, and it falls before the end of the next payroll period.
You are paid twice a month. For the normal payroll period which begins on the first of the month and ends on the fifteenth of the month, you are paid on the sixteenth day of the month. For the normal payroll period that begins on the sixteenth of the month and ends on the last day of the month, you are paid on the first day of the following month. Because all of the above conditions are met, the pay you received on January 1, 2020, is considered earned in 2020.
Part Year Exclusion
If you qualify under either the bona fide residence test or the physical presence test for only part of the year, you must adjust the maximum limit based on the number of qualifying days in the year. The number of qualifying days is the number of days in the year within the period during which you have your tax home in a foreign country, and are either a bona fide resident of a foreign country or meet the physical presence test. To figure your maximum exclusion, multiply the maximum exclusion amount for the year by the number of your qualifying days in the year, and then divide the result by the 365 (366 if a leap year).
You establish a tax home and bona fide residence in a foreign country on August 14, 2019. You maintain the tax home and residence until January 31, 2021. You are a calendar year taxpayer. The number of days in your qualifying period that fall within your 2019 tax year is 140 (August 14 through December 31, 2019). Your maximum exclusion for 2019 is $40,619 (140/365*$105,900).
Physical Presence Test
Under the physical presence test, a 12-month period can be any period of 12 consecutive months that includes 330 full days of presence in a foreign country. If you qualify under the physical presence test for part of a year, it is important to carefully choose the 12-month period that will allow the maximum exclusion for that year.
NOTE: Form 2555, Foreign Earned Income will help you with these computations.
In order to compute the foreign earned income exclusion, you must first know the amount of your:
- Foreign earned gross receipts
- Expenses definitely related to the foreign earned gross receipts
- Deduction for ½ self-employment tax
The exclusion amount will be reduced by the pro rata share of your expenses and self-employment tax deduction. This is because you cannot take deductions against amounts excluded from income.
For example, you operated a service business in a foreign country during all of 2019 and your:
- Schedule C Gross Receipts were $150,000
- Schedule C Expenses were $50,000
- Schedule C Net Income was $100,000
- Self-Employment (SE) Tax was $14,130
- Deduction for ½ SE Tax was $7,065
You would compute your exclusion this way:
For tax year 2019, the maximum foreign earned income exclusion amount was the lesser of the foreign income earned or $105,900 per qualifying person. Since you are excluding $105,900 of your $150,000 gross receipts, you will need to multiply that same ratio by the expenses that are directly related to your Schedule C gross receipts, as follows:
($105,900 ÷ $150,000) x ($50,000 + $7,065) = $40,288 of expenses allocable to excluded income
This amount, $40,288, is then subtracted from the $105,900 to arrive at $65,612, which is entered on Line 45 of Form 2555, Foreign Earned Income, and is then entered as a negative amount on the appropriate line of Schedule 1 (Form 1040), with the notation “Form 2555”.