What is Foreign Earned Income?

Foreign earned income refers to income earned by U.S. citizens or resident aliens from working in a foreign country. This includes wages, salaries, bonuses, and self-employment income that you receive while living abroad. It’s important to understand that not all types of foreign income qualify as foreign and earned income.

For example, income such as dividends, capital gains, or rental income are considered passive income and are not eligible for specific exclusions or deductions like the Foreign Earned Income Exclusion (FEIE).

To be considered foreign earned, the income must be generated from performing services in a foreign country and does not apply to income earned within the U.S., even if you are living abroad. This is particularly relevant when reporting your worldwide income on your federal income tax return.

Types of Foreign Earned Income

• Salaries and Wages: Payments received for employment services performed in a foreign country.
• Bonuses and Allowances: Additional compensation provided by employers for work done abroad.
• Self-Employment Income: Earnings from conducting business activities or freelance work in a foreign country.
• Professional Fees: Income from services rendered in a professional capacity, such as consulting or independent contracting.

How Is Foreign Income Sourced?

Understanding sourcing rules is essential for determining whether your income qualifies as foreign earned income and how it will be taxed by the U.S. government. The source of income refers to the location where the income is generated or the services are performed, which plays a significant role in determining tax treatment.

How Are Wages and Salaries Sourced?

Earned income such as wages, salaries, and bonuses is considered foreign earned income if the work is performed in a foreign country. For instance, if a U.S. citizen is employed in France, the salary earned there is treated as foreign earned income, regardless of whether the employer is based in the U.S. or elsewhere. This is crucial when determining eligibility for the FEIE.

How Is Investment Income Sourced?

Investment income follows different sourcing rules and is generally not classified as foreign earned income. Here’s how it works:

• Interest: The source of interest income depends on the residence of the payer. If a foreign bank or entity pays the interest, it is considered foreign source income.
• Dividends: The source of dividend income is tied to the location where the corporation paying the dividend is incorporated. Dividends from a foreign corporation are considered foreign source income, while dividends from a U.S.-based company are treated as U.S. source income, regardless of where the recipient resides.

How Are Capital Gains Sourced?

Sourcing rules for capital gains depend on the type of asset being sold, making it more complex:

• Real Estate: The sale of foreign real estate is classified as foreign source income, while the sale of U.S. property is U.S. source income. For example, if a U.S. expat sells a rental property in Germany, the capital gains from that sale are considered foreign income.
• Stocks: The sourcing of capital gains from the sale of stocks depends on the residence of the taxpayer, rather than the location of the stock exchange or the corporation. Even if you sell shares of a foreign company, if you’re a U.S. citizen, the capital gains may still be considered U.S. source income unless otherwise specified by an income tax treaty.

By understanding these sourcing rules, U.S. taxpayers living abroad can better identify which types of income are classified as foreign earned income and which are subject to different tax treatments. This is important for eligibility for the FEIE, Foreign Tax Credit, and other tax benefits designed to help avoid double taxation on foreign income.

Related: Foreign Earned Income Exclusion vs Foreign Tax Credit: Which one is better?

Who Is Eligible for the Foreign Earned Income Exclusion?

The FEIE allows U.S. citizens and resident aliens living in a foreign country to exclude a certain amount of their foreign earned income from U.S. taxation. For the 2023 tax year, the exclusion limit is set at over $120,000 per year. However, to qualify for this exclusion, you must meet certain eligibility criteria.

There are two primary ways to qualify for the Foreign Earned Income Exclusion:

1. Physical Presence Test: You must be physically present in a foreign country or countries for at least 330 full days within any 12-month period. This doesn’t require you to be a permanent resident of the foreign country, just that you spend enough time there during the tax year.
2. Bona Fide Residence Test: To qualify under this test, you must have a tax home in a foreign country and establish a bona fide residence for an uninterrupted period that includes an entire tax year. This requires that you genuinely reside in a foreign country with no immediate plans to return to the U.S., as evaluated by the Internal Revenue Service (IRS).

How Does the FEIE Work?

The FEIE is a way for U.S. citizens and resident aliens to reduce their taxable income by excluding up to $120,000 (adjusted annually) of their foreign earned income from U.S. taxation. The exclusion applies to income earned while living and working in a foreign country, which helps individuals avoid double taxation on their income.

In addition to the FEIE, there are other benefits you may be eligible for, such as the Foreign Housing Exclusion or Foreign Housing Deduction. These allow you to exclude or deduct certain housing costs incurred while living abroad. For example, housing costs like rent and utilities may be excluded from your taxable income if they exceed a certain percentage of your foreign earned income.

How to Claim the Foreign Earned Income Exclusion?

To claim the FEIE, you must file IRS Form 2555 along with your federal income tax return. Form 2555 helps determine how much of your foreign earned income qualifies for the exclusion and whether you meet the Physical Presence Test or Bona Fide Residence Test. It’s important to keep in mind that this exclusion only applies to earned income and not to other types of foreign income, such as investment income or foreign dividends.

In cases where you also pay taxes to a foreign government, you may be eligible for the Foreign Tax Credit. This credit is designed to further reduce your U.S. tax liability by allowing you to claim a credit for foreign income taxes paid. This ensures that you don’t pay taxes twice on the same income—a situation commonly referred to as double taxation. You can claim the Foreign Tax Credit using IRS Form 1116.

Understanding the rules surrounding foreign earned income, the FEIE, and other tax benefits such as the Foreign Tax Credit is crucial for U.S. expats looking to reduce their tax obligations and avoid double taxation. Properly identifying and reporting income ensures compliance with U.S. tax law and maximizes your tax benefits while living abroad.

At 1040 Abroad, we specialize in helping U.S. expats navigate these complex tax matters, and we offer free tax advice to help you make informed decisions about your finances. Reach out to us today for personalized guidance on your tax situation.