Expat Income Taxation in the U.S. and Form 2555 Exclusions
Introduction
U.S. citizens and resident aliens living abroad are subject to U.S. income tax on their worldwide income, regardless of where they reside. This can lead to double taxation, where income is taxed both by the United States and the host country. To mitigate this, the Internal Revenue Code (IRC) provides mechanisms such as the foreign earned income exclusion and the foreign housing exclusion or deduction, which can be claimed using Form 2555. This article explores how expat income is taxed in the U.S. and the specifics of Form 2555 exclusions.
Taxation of Expat Income
Worldwide Income
U.S. citizens and resident aliens are taxed on their worldwide income. This includes wages, salaries, and other compensation for services performed abroad, as well as income from investments and other sources. The U.S. tax system requires these individuals to file annual tax returns and report all income, regardless of where it is earned.
Double Taxation Relief
To alleviate the burden of double taxation, the IRC offers two primary mechanisms:
- Foreign Earned Income Exclusion (FEIE): Allows qualifying individuals to exclude a certain amount of foreign earned income from their U.S. taxable income.
- Foreign Tax Credit (FTC): Provides a credit for foreign taxes paid on income that is also subject to U.S. tax.
Foreign Earned Income Exclusion (FEIE)
Eligibility
To qualify for the FEIE, an individual must meet the following criteria:
- Tax Home in a Foreign Country: The individual’s tax home must be in a foreign country. A tax home is generally the location of the individual’s main place of business or employment.
- Bona Fide Residence Test or Physical Presence Test:
- Bona Fide Residence Test: The individual must be a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year.
- Physical Presence Test: The individual must be physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.
Exclusion Amount
For 2023, the maximum exclusion amount is $120,000. This amount is adjusted annually for inflation. If an individual qualifies under either the bona fide residence test or the physical presence test for only part of the year, the exclusion amount is prorated based on the number of qualifying days.
Foreign Housing Exclusion or Deduction
Housing Amount
The housing amount is the excess of the individual’s housing expenses over a base amount. Housing expenses include rent, utilities (excluding telephone charges), real and personal property insurance, and other reasonable expenses related to housing.
Base Housing Amount
The base housing amount is 16% of the maximum foreign earned income exclusion, calculated on a daily basis. For 2023, this amount is $19,200 annually or $56.60 per day.
Limits on Housing Expenses
The maximum amount of housing expenses eligible for the exclusion or deduction is generally 30% of the maximum foreign earned income exclusion, calculated on a daily basis. For 2023, this is $36,000 annually or $98.63 per day. However, this limit can vary depending on the location of the foreign tax home.
Form 2555: Foreign Earned Income
Purpose
Form 2555 is used to claim the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction. It helps determine the amount of foreign earned income and housing costs that can be excluded or deducted from U.S. taxable income.
Filing Requirements
To claim the exclusions or deductions, individuals must file Form 2555 with their annual tax return (Form 1040 or 1040-SR). The form must be completed and attached to the tax return to substantiate the claim.
Key Sections of Form 2555
- Part I: General Information: Includes personal information, tax home details, and the type of exclusion or deduction being claimed.
- Part II: Bona Fide Residence Test: Documents the period of bona fide residence in a foreign country.
- Part III: Physical Presence Test: Documents the period of physical presence in a foreign country.
- Part IV: Foreign Earned Income: Details the amount of foreign earned income received during the tax year.
- Part VI: Foreign Housing Exclusion or Deduction: Calculates the housing exclusion or deduction based on housing expenses and the base housing amount.
Tax on Non-Excluded Income
If an individual claims the foreign earned income exclusion or the housing exclusion, they must figure the tax on their non-excluded income using the tax rates that would have applied had they not claimed the exclusions. This is known as the “stacking rule” and ensures that the excluded income does not push the non-excluded income into a lower tax bracket.
Conclusion
U.S. citizens and resident aliens living abroad can benefit from the foreign earned income exclusion and the foreign housing exclusion or deduction to reduce their U.S. taxable income. Form 2555 is essential for claiming these benefits and must be filed with the annual tax return. By understanding and utilizing these provisions, expatriates can effectively manage their U.S. tax obligations while living and working abroad.
Author of this article Jack Chaudhary specializes in Individual, Corporate Tax returns, Foreign Taxes, Expats, Non-resident Taxes, Payroll, Crypto and e-Commerce. With the Enrolled Agent credential, Jack represents taxpayers before the IRS and state taxing authorities. He zealously advocates for his clients to ensure the best results are achieved. Book an appointment here with him for a consultation call.
