Editor’s Note: This article only applies to United States citizens, and we are not—nor do we pretend to be—certified tax professionals. Nothing you read in this article should be taken as tax advice, and a proper CPA should be consulted.
If you’re like most of us here at The Anywhere Company, you spend a lot of time in the air and on the ground in exotic locations around the world. Our lifestyles not only allow us to explore vastly different cultures, people, and places all over the world; they also allow us to significantly reduce our yearly tax burdens by taking advantage of little-known tax benefits.
This is part one of a three-part series covering foreign-earned income exclusion (FEIE for short). We’ll break down exactly what it is, what it’s not, how to qualify, the step-by-step process of claiming the income exclusion, and much more.
What do the United States, North Korea, and Eritrea (a small country in Africa, just north of Ethiopia) have in common?
Palpable tension with bordering countries, and some of the largest military forces on their respective continents? Yes, but no.
These are the only three countries in the world that enforce a worldwide, citizenship-based income tax. This means that as a citizen of any of these countries, you’re required to pay taxes on every dollar earned regardless of where those dollars came from, and where you were when they hit your bank account.
Live and work in Thailand with European clients? Taxes.
Constant travel with no permanent home while you freelance from your computer? Taxes.
You get the picture: taxes and death remain entrenched as the two unconquerable, heavyweight champions of inevitability.
Or do they…?
Enter Foreign-Earned Income Exclusion
As far as I know, death remains unavoidable; federal income tax, however, is on shaky legs thanks to a little-known claimable benefit called: foreign-earned income exclusion.
So what is it?
Foreign-earned income exclusion is, officially, an IRS-approved method for international taxpayers such as digital nomads and expats to avoid double taxation; an analog to many countries’ systems that allow non-resident citizens to ‘opt-out’ of national taxation.
In theory, the thought process behind FEIE is that U.S. taxpayers abroad are already paying taxes to the country they’re living in, so it doesn’t make sense to tax them again. In practice, the reality is different in that not all expats, or nomads, are paying taxes to other countries.
Regardless, so long as you claim FEIE, and meet a few light qualification requirements, you can exclude a significant amount of personal income from your federal income taxes. $105,900 for the 2019 tax year, to be exact, and that number rises every year to keep pace with inflation.
Who does foreign-earned income exclusion benefit?
Short answer: digital nomads who live a life of perpetual travel outside the U.S.A.
Long answer: it depends entirely on who is able to meet the FEIE qualification requirements which aren’t impossibly strict, but also aren’t a walk in the park either. Theoretically, anyone who lives and works outside of the U.S., or spends a significant amount of time off U.S. soil, stands to benefit from FEIE.
I know you’re craving the nitty-gritty how-to’s, but let’s clear up a few common misunderstandings regarding international taxpayers and foreign-earned income exclusion first. We’ll go over the qualification requirements in part two of this three part series.
Think You’re Off the Tax Hook Once You Leave the U.S.? Think Again.
Many people mistakenly assume that once they leave the U.S. to travel for extended periods of time, or live in another country, they’re no longer required to to file a yearly tax return.
This is unequivocally false.
All United States citizens are required to file a tax return every single year, so long as their gross income exceeds the minimum reporting threshold. That threshold, as of 2019, is $12,000 for single filers under the age of 65 (use this IRS interactive tax tool to help you determine your minimum income requirements for filing).
If you’re like me, you were one of the people that assumed nothing was required of you once you left the United States, so you didn’t file any returns. This opens the door to a possible audit, and if you’re found to be in violation of your tax obligations, you will have to pay penalty fees on top of the back-taxes you owe. Not a good situation to be in.
Fortunately, the IRS implemented a ‘Streamlined Filing’ program in 2012 that allows taxpayers to file amended or delinquent returns for the most recent three tax years. So long as you can prove—and you will be required to—that your delinquency was non-willful, or due to ignorance of your tax obligations, you can catch-up on back-taxes penalty-free.
If you just read the last three paragraphs, and haven’t been filing yearly tax returns, your delinquency can now be considered willful; exempting you from any penalty-free catch-up.
Sometimes ignorance truly is bliss.
The only thing that FEIE does is reduce your federal income tax by allowing you to exclude a certain amount of particular types of income from your yearly tax return.
As with yearly returns, the mistaken assumption of total tax non-obligation once off U.S. soil is false. Even if you qualify for, and claim foreign-earned income exclusion, you’re still responsible for:
- Social Security and Medicare taxes (or self-employment tax if you’re not an employee)
- State taxes (if applicable)
- City taxes (if applicable)
There are strategies to eliminate these taxes, but you’re still obligated to handle them every year—or only once in the case of state and city taxes.
Reducing or Eliminating Social Security and Medicare/Self-Employment Taxes
Briefly, Social Security and Medicare, or self-employment taxes are 15.3% of your eligible gross income.
- 12.4% of this is for Social Security, and you’re obligated to pay that rate on your first $132,900 of gross income for 2019. Everything above that is Social Security tax-free
- 2.9% of this is for Medicare, and all of your gross income is taxed at this rate regardless of how much you earned in that year
If you’re an employee, you split this 15.3% with your employer right down the middle; meaning your Social Security and Medicare obligation is reduced to 7.65% of eligible wages.
If you’re a business-owner, freelancer, independent contractor, or any other type of self-employed individual, the entire 15.3% is on your shoulders. Fortunately though, you can write off 7.65% of that as a business expense.
It’s possible to eliminate Social Security and Medicare, or self-employment taxes through two avenues:
- By living in, and paying into a Social Security and Medicare equivalent tax program in a foreign country which has a totalization agreement with the United States (a list of all countries with these agreements can be found here)
- Becoming an employee of a foreign company (more information can be found here)
To those practicing ‘Flag Theory’ (leveraging international mobility to reduce taxes, increase your bottom line, and protect your assets), becoming an employee of a foreign company is typically the most popular way to reduce SE (self-employment) taxes.
It’s easy to see why when you can establish a foreign company in less than a month, for under $10,000, rather than deal with the additional bureaucratic headaches, and residency limitations entering another national tax system would cause you.
Eliminating State and City Taxes
The interaction between foreign earned income exclusion, state, and city taxes is complicated; every state, and every city has their own procedure for handling the taxation of citizens within their jurisdiction, so it’s unrealistic to break it all down here.
But briefly, if you are considered a resident of a state or city, you’re subject to their tax policies, and you will typically have to go through a formal process of officially breaking residency if you wish to end your obligations. And this is where it gets complicated.
Some ride on the coattails of federal law saying in effect, “If you qualify for foreign earned income exclusion, we don’t consider you a resident, and you don’t have to pay any taxes here.”
Others—like California—are much stricter, and require you to jump through additional hoops to break your residency status.
Residency status is always judged on a case-by-case basis, so there’s no exact recipe for breaking it. However, the most common way to officially claim non-resident status is to prove that you have little to no intention of returning by breaking various social and economic ties such as:
- Selling your home and large possessions (e.g. car, furniture, etc.)
- Switching from a residential mailing address to a P.O. box
- Eliminating any debts, utilities, and mortgage payments
- Renouncing membership in any U.S.-based clubs or organizations
As I said above, it’s complicated; be sure to consult your state’s Department of Revenue (here’s a list of all 50 websites) for information specific to you, and consult a proper professional.
Not All Types of Income Qualify for Exclusion Underneath Foreign-Earned Income Exclusion
Officially, the IRS states that only “active income”, or more commonly “earned income”, is claimable. “Earned Income” is defined as: “…pay for personal services performed, such as wages, salaries, or professional fees.”
Essentially, what the IRS is looking for here is money actively earned. Most any income type that could be defined as ‘passive income’ generally falls under the category of “unearned income”, and is therefore not available for exclusion.
Types of income considered “earned income”, and therefore open-season for exclusion includes:
- Salaries and wages
- Professional fees
- Fair market value of property or facilities provided to you by your employer in the form of lodging, meals, or use of a car
- Received allowances or reimbursements
- Pay for services performed in U.S. combat zones*
*Before the Bipartisan Budget Act of 2018 (which you can read here), taxpayers who lived and worked in specified combat zones were determined to be ineligible for foreign-earned income exclusion. This has been repealed, and whether you live and work in a combat zone or non-combat zone, your income is eligible for exclusion (so long as it meets the other “earned” or “active” qualifications).
Types of income considered “unearned income”, and therefore not open for exclusion includes:
- Capital gains
- Gambling winnings
- Stock trading, forex trading, day trading, cryptocurrency trading, etc.
- Social security benefits
- IRA distributions
- Social Security benefits
- Pay received as an employee of the U.S. government
- Pay for services performed in international waters
Types of income that exist in an FEIE gray area, and are therefore potentially open for exclusion (depending on the specifics of the situation) includes:
- Business profits
- Scholarships and fellowships
- Profits from flipping real estate
- Income received as a professional stock trader
If you’re like us here at The Anywhere Company, the holy grail of your financial life is a steady stream of ‘passive’ income, significant enough to support your desired lifestyle (e.g. rental income or capital profits from business systems, as opposed to trading your time for money). Just know—and be sure to calculate for—that once you get there, federal income taxes will be essentially unavoidable without a very creative tax strategy.
If you have questions about non-standard income types, be sure to consult this IRS guide on what constitutes “earned” and “unearned” income as it related to Foreign Earned Income Exclusion.
Your Tax Bracket Won’t Change Regardless of How Much Income You Exclude
Any “earned income” above 2019’s $105,900 maximum exclusion amount—you may be able to exclude more than this under the ‘Foreign Housing Exclusion’ benefit, but more on that later—and any “unearned income” is going to be taxed by the federal government.
It would be a wonderful additional benefit if your claimed exclusion was able to alter which tax bracket you find yourself in, but unfortunately that’s not the case. Excluding income will not change your tax bracket, so every taxable dollar will be subject to the same bracket rate you would have paid had you not claimed any exclusion.
As a quick example, let’s say your income for the 2019 tax year is $200,000 placing you in the 32% tax rate bracket. You qualify for FEIE, and successfully exclude the maximum $105,900 from your federal income tax obligation leaving $94,100 of federally taxable income. That remaining $94,100 will be taxed at the same 32% rate, as opposed to the 24% tax bracket a total yearly income of $94,100 would place you in. In the end, you’ll pay $30,112 in federal taxes, and not $22,584.
You Might Be Able to Exclude More than the $105,900 Maximum
“Foreign Housing Exclusion”, or “Foreign Housing Deduction” is an international taxpayer benefit which allows you to exclude a certain amount of gross income attributable to foreign housing expenses from your federal tax return.
The great thing about this benefit is that if you qualify for foreign-earned income exclusion, you automatically qualify here. Meaning you’ll likely be able to exclude more than the FEIE-stated maximum of $105,900 for the 2019 tax year.
Under this benefit you can exclude “reasonable” housing expenses paid for housing in a foreign country. “Lavish” or “extravagant” expenses cannot be excluded, so it’s probably best to pocket your plans for golden nude statues of yourself for now.
The calculation for total gross income eligible for foreign-housing exclusion is complex. We’ll cover it in more detail in part two, but here it is very briefly:
You can exclude gross income paid for foreign housing expenses in excess of 16% of the yearly maximum foreign-earned income exclusion, but no more than 30% of the FEIE maximum.
Yeah, my head hurts too…
To break that down further, costs incurred for foreign housing expenses in excess of $16,944, but less than $31,770, can be excluded from your 2019 federal income tax. This brings the maximum excludable amount for foreign housing to $14,826.
Here’s the math on that:
- 16% of 2019’s FEIE max = $16,944
- 30% of 2019’s FEIE max = $31,770
- 2019 maximum foreign-housing exclusion = ($31,770 – $16,944) = $14,826
This, in combination with foreign-earned income exclusion’s maximum exclusion amount, means you can potentially exclude a total of $120,726 from your 2019 federal income taxes.
Not bad at all.
Whew… Let’s Recap
That was a lot of information, so let’s recap before we move on:
- You have to file a tax return every single year, no matter who you are or where you live
- ‘Foreign-earned income exclusion’ is a tax benefit for U.S. taxpayers living abroad. It allows you to exclude a maximum of $105,900 from your 2019 federal income taxes
- Only “active” or “earned” income is excludable. Generally, that means income earned directly from services performed (passive income is not excludable)
- Foreign-earned income exclusion does not relieve you of Social Security and Medicare, State, or City tax obligations
- Any taxable income after accounting for FEIE will be taxed at the rate of your tax bracket your total gross income (including excluded income) places you in
- You can exclude an additional $14,826 from your 2019 federal income taxes for expenses incurred for foreign housing; otherwise known as Foreign-Housing Exclusion
In part two of this series we’ll break down exactly how you qualify for FEIE. It will help you figure out if this is relevant to you, and how to calculate your maximum exclusion amount if you do qualify.
*We’d like to thank the wonderful people over at Bright!Tax for their help with this article. Everyone we spoke with was truly knowledgeable, and genuinely happy to help us understand foreign-earned income exclusion, so we could help you understand it. If you have any questions regarding FEIE, or you want help claiming the your benefits, we highly recommend Bright!Tax and their expert CPAs.