This discussion is not intended as legal or tax advice, and cannot be relied upon for any purpose without the services of a qualified professional.
The Foreign Earned Income Exclusion allows expats to exclude foreign earned income and exclude or deduct housing reimbursements while living abroad. Also, foreign taxes paid may be claimed as itemized deductions or a credit on your federal return. You also may be entitled to exclude from income the value of meals provided if they are required by your employer.
To claim the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, you must meet all three of the following requirements. Your tax home must be in a foreign country. You must have foreign earned income. You must be a U.S. citizen who is a bona fide resident of a foreign country (generally from at least January 1 through December 31) or who is physically present in a foreign country for at least 330 full days during any period of 12 consecutive months.
DEFINING WHAT THE IRS CONSIDERS A TAX HOME
Your tax home is determined by the primary location of your employment or business. If your primary residence is in the United States, you are generally not considered to have lived abroad during the tax year. On the other hand, owning a home in the U.S. does not establish there as your tax home; nor does the fact that your spouse or dependents use the dwelling.
If you are temporarily away from your tax home in the U.S. on business, you may be able to deduct your away-from-home expenses (for travel, meals, and lodging), but you do not qualify for the foreign earned income exclusion.
If the duration of your foreign work or business is for an indefinite period, your new place of employment becomes your tax home. You may qualify for the foreign income exclusion but you would not be able to deduct any of the related expenses.
It is interesting to note that the IRS instructions for “tax home” and “bona fide resident” do not include the requirement to pay income tax to the foreign government. According to the IRS, your tax home is where you run your business or earn your salary.
The IRS instructions do state that if;
- You make a statement to the foreign government that you are not a resident of that country and
- The foreign government holds that you are not subject to their income tax laws, and then you do not pass the bona fide resident test. It may appear to some that a “grey area” exists here. How would a foreign government know if a foreign resident of theirs was earning a salary from an IBC (international business corporation) or a foundation established in the Seychelles, Belize, St. Kitts/Nevis or Hong Kong? Instead of a salary, what if those payments were characterized as, say, pension or severance? For both of these in Mexico, there is a high threshold to reach taxability.
Although slowly changing, taxation of income from outside of Mexico earned by a U.S. citizen permanently residing in Mexico is currently not often enforced. Effective tax planning should never depend on such an assumption but in practice sometimes does. Most accountants would prefer advising their clients to maximize deductions for officer pensions, corporate provided vehicles, client entertainment, children’s employment and their college tuition, corporate paid travel, “office” improvements, furniture and utilities, employment of family member consultants and health/medical insurance/procedures.
The maximum foreign income exclusion for 2015 is $100,800 for an individual, ($201,600 for husband and wife) of salary or active trade or business and is adjusted annually for inflation. The income must be for services performed in the country of residence. Foreign-earned income is income you receive for working in a foreign country. Where or how you are paid has no effect on the source of the income.
EARNED VERSUS UNEARNED INCOME
Generally, rental income is unearned income. If you perform personal services in connection with the production of rent, up to 30% of your net rental income can be considered earned income. Dividends, interest, capital gains, pensions and social security benefits are not earned income.
In most cases, if you are reimbursed for employee expenses under an accountable plan, the reimbursement is not earned income and is not reportable.
Reimbursement of moving expenses is usually considered earned income.
Employer provided housing falls under two categories:
If you have a choice to use your employer’s foreign housing, its fair market value is earned income, and must be included in the computation of the foreign earned income exclusion.
If your employer provides lodging to you or your family and you must accept the lodging as a condition of employment , its value is not earned income to you. The same is true with meals if provided as a condition of employment.
To claim the exclusion, you must file a U.S. federal tax return that reports the foreign earned income. Use form 2555 to report the foreign earned income exclusion, the foreign housing exclusion and the foreign housing deduction. Speaking of IRS tax forms, use form TD 90-22.1 to report foreign bank account earnings if the account had over $10,000 at any time of the year.
The housing amount is considered to be the excess of allowable housing expenses for the tax year over a given base amount. The allowed expenses for you, spouse and dependents must be reasonable, such as rent, personal property insurance, rental of furniture and accessories, repairs, residential parking and utilities, but not cellular usage. You are also allowed to include the rental value of housing provided by an employer in exchange for your services.
The amount of qualified housing expenses eligible for the housing exclusion and housing deduction is also limited. The limitation on housing expenses is generally 30% of the maximum foreign earned income exclusion. For the 2014 tax year, the housing amount limitation is $39,400 for the east coast of Mexico and $37,900 for Merida, Mexico.
The foreign earned income exclusion is foreign earned income minus the foreign housing exclusion.
The housing cost amount is the total of your foreign housing expenses for the year minus a base housing amount. The base housing amount is 16 percent of the maximum foreign earned income exclusion for the tax year.
The limitation on foreign housing expenses is 30 percent of the maximum foreign earned income exclusion.
In contrast to the foreign housing exclusion, the foreign housing deduction is the tax benefit available to individuals with self-employment earnings. The self- employed are still liable for U.S. self-employment tax (social security and Medicare).
If you incur Mexican income taxes, limited amounts of taxes paid can be credited against your federal tax liability. If subject to U.S. social security and Medicare taxes, expect to be exempt for the same taxes in a foreign country if it entered into a Totalization Agreement with the U.S.
If you are a United States resident or citizen who is living and working abroad, then you are normally granted an automatic extension to file federal income taxes until June 15th. A statement declaring eligibility for the extension must be included with the return.