Americans working overseas are still responsible for filing US tax returns and paying US tax (despite what your fellow ex-pat at the bar may have told you!). Fortunately, the IRS allows a couple of ways to minimize or completely avoid US tax on income earned overseas: the foreign tax credit, and the foreign earned income exclusion (FEIE). If you’re working in a country with no income tax, or a very low income tax, you’re probably going to want to claim the FEIE.
The FEIE allows a taxpayer to exclude over $90,000 of income earned overseas and pay no tax on it. Plus you get to exclude an additional amount for housing costs. This additional amount starts at about $27,000, but can be well over $50,000 if you’re in a high-cost location. Most people who take foreign jobs hear about this exclusion and are happy to apply it. However, most people don’t get the full value they’re entitled to in the year they move overseas or the year they return.
One way to qualify for this exclusion is the Physical Presence Test. This means you’re simply present in a foreign country for 330 days in a one year period. It doesn’t have to be the same foreign country for all 330 days, and the one year period can start or end on any day of the year. Most people choose a 12-month period that starts on the day they arrive, or ends on the day they leave. This is logical, but it might be costing you money.
It’s important to pick the 12-month period that maximizes your exclusion (even the IRS says so!), because if your 12-month period only covers part of the year, you have to prorate your exclusion. So let’s say you move overseas on July 1, and you remain in the foreign country for the next 365 days. Most people would use the 12-month period from July 1 in the current year to June 30 in the next year. If you do that, you could be costing yourself thousands of dollars. If you stayed in a foreign country that whole time, you could actually start your 12-month period on May 26 and still have 330 days in a foreign country in a 1 year period.
Why is this so important?
The extra 35 days in your “qualifying period” get you a significantly larger exclusion amount when you pro-rate the annual exclusion. In this case, the extra days would result in you being able to exclude almost $9,000 more foreign income. The way the exclusion works, that could easily make a difference of over $2,000 in the tax you pay. So don’t short-change yourself! In the year you move to or from a foreign country for a job, it’s usually a good idea to use the Physical Presence Test and choose a 12-month period with as many days in the tax year as possible. IRS Publication 54 actually outlines the step by step process of how to do this in chapter 4, so I’m just going to include the instructions (from 2010) right here:
If you qualify for the foreign earned income exclusion 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.
You are physically present and have your tax home in a foreign country for a 16-month period from June 1, 2009, through September 30, 2010, except for 16 days in December 2009 when you were on vacation in the United States. You figure the maximum exclusion for 2009 as follows.
- Beginning with June 1, 2009, count forward 330 full days. Do not count the 16 days you spent in the United States. The 330th day, May 12, 2010, is the last day of a 12-month period.
- Count backward 12 months from May 11, 2010, to find the first day of this 12-month period, May 12, 2009. This 12-month period runs from May 12, 2009, through May 11, 2010.
- Count the total days during 2009 that fall within this 12-month period. This is 234 days (May 12, 2009 – December 31, 2009).
- Multiply $91,400 (the maximum exclusion for 2009) by the fraction 234/365 to find your maximum exclusion for 2009 ($58,596).
You figure the maximum exclusion for 2010 in the opposite manner.
- Beginning with your last full day, September 30, 2010, count backward 330 full days. Do not count the 16 days you spent in the United States. That day, October 19, 2009, is the first day of a 12-month period.
- Count forward 12 months from October 19, 2009, to find the last day of this 12-month period, October 18, 2010. This 12-month period runs from October 19, 2009, through October 18, 2010.
- Count the total days during 2010 that fall within this 12-month period. This is 291 days (January 1, 2010 – October 18, 2010).
- Multiply $91,500, the maximum limit, by the fraction 291/365 to find your maximum exclusion for 2010 ($72,949).
One last note I find interesting. The tax code itself actually states that “qualifying days” are days when the taxpayer meets one of the foreign residence tests (either Physical Presence or Bona Fide Residence) AND has a tax home in a foreign country. Since a “tax home” requires having a home and job overseas, my intuition would be that if your 12-month period starts before you arrive overseas, this would NOT increase your qualifying days, and therefore your pro-rated exclusion, because you don’t have a tax home until you arrive. Fortunately, the IRS has apparently in this case defied intuition in FAVOR of the taxpayer. If you’re one of those people who can save a few hundred, or a few thousand, dollars by using this trick, let’s hope the IRS continues to be so generous with this!