Foreign Earned Income Exclusion for a Partial Year

The Foreign Earned Income Exclusion (FEIE) provides a tax benefit for U.S. citizens and resident aliens who live and work abroad, allowing them to exclude a portion of their foreign income from U.S. income tax. The rules can be applied for only part of the tax year, a situation that often arises when a person moves away from or returns to the United States.

Qualifying for the Exclusion in a Partial Year

To claim the Foreign Earned Income Exclusion, an individual must first have their tax home in a foreign country. A tax home is the location of a person’s primary place of business or employment, regardless of where they maintain their family home. Once the tax home test is met, the individual must then satisfy either the Bona Fide Residence Test or the Physical Presence Test.

The Bona Fide Residence Test requires an individual to be a resident of a foreign country for an uninterrupted period that includes an entire tax year. This means the residency must span from January 1 through December 31. Because of this full-year requirement, it is less common for taxpayers to qualify under this test in a year they move to or from the U.S.

The Physical Presence Test is more commonly used for partial-year qualifications. This test requires a U.S. citizen or resident to be physically present in a foreign country for at least 330 full days during any consecutive 12-month period. The 12-month period can begin on any day of the month, offering flexibility for those who move mid-year.

For example, if a taxpayer moves to a foreign country on July 1, 2023, they can establish a 12-month period running from that date until June 30, 2024. If they are physically present in a foreign country for at least 330 days within that 12-month window, they have met the test. This allows them to exclude income earned during the portion of 2023 that falls within this qualifying period, from July 1 to December 31.

Calculating the Partial Year Exclusion Amount

Once you determine that you qualify for the FEIE for a portion of the year, you must calculate the maximum amount you can exclude. The exclusion amount must be prorated based on the number of qualifying days. The Internal Revenue Service (IRS) sets a maximum annual exclusion limit each year; for tax year 2024, this amount is $126,500.

To determine the prorated exclusion, you divide your number of qualifying days in the tax year by the total number of days in that year (365, or 366 in a leap year) and then multiply the result by the maximum annual exclusion amount. The “qualifying days” are the days within your established 12-month period or period of bona fide residence that fall within the tax year for which you are filing.

Consider a taxpayer who establishes a qualifying period under the Physical Presence Test that begins on March 1, 2024. For their 2024 tax return, their qualifying days would be from March 1, 2024, to December 31, 2024, which is 306 days. The calculation would be (306 / 366) x $126,500, resulting in a maximum exclusion of $105,574 for 2024. This prorated amount represents the ceiling for the exclusion, as the actual amount you can exclude is the lesser of this prorated maximum or your total foreign earned income during that specific period.

Information and Forms for Claiming the Exclusion

To claim the partial-year Foreign Earned Income Exclusion, you must file Form 2555, Foreign Earned Income, with your U.S. tax return. You will need to gather several pieces of information to complete the form, including:

• A detailed travel calendar with the exact dates of your arrival in and departure from foreign countries.
• Your foreign address.
• Your employer’s name and address.
• A clear record of your foreign earned income for the qualifying period.

Form 2555 is structured to walk you through the qualification tests and the exclusion calculation. In Part II of the form, you will enter the start and end dates of your 12-month qualifying period for the Physical Presence Test and provide your travel details. Part IV is where you will report your total foreign earned income for the year, and the form then guides you to calculate your prorated exclusion limit.

The Tax Stacking Rule for Partial Year Filers

Claiming the FEIE, whether for a full or partial year, involves the application of the “stacking” rule when calculating your final tax liability. This rule affects how your non-excluded income is taxed. Even though your foreign earned income is excluded from your taxable income, it is temporarily added back in to determine the tax rate that will be applied to your remaining, non-excluded income.

The calculation works by first figuring the tax on your total income, including the amount you excluded with Form 2555. Then, a separate tax calculation is done on only the excluded income amount. The tax from the second calculation is subtracted from the tax of the first calculation, and the result is your actual tax liability.

For example, imagine a taxpayer has $150,000 of total income and a prorated FEIE of $90,000, leaving $60,000 of non-excluded income. Under the stacking rule, the tax is first calculated on the full $150,000, which pushes the income into higher tax brackets. The tax attributable to the $90,000 exclusion is then subtracted, but the remaining tax on the $60,000 is computed at the higher marginal rates applicable to income between $90,001 and $150,000, not the lower rates for income from $0 to $60,000.