Qualifying for Tax Exempt Foreign Income

U.S. citizens and resident aliens are subject to tax on their worldwide income, regardless of where they live. This policy can lead to being taxed by both the United States and a foreign jurisdiction. To alleviate this double taxation, the tax code provides mechanisms to exclude a certain amount of income earned abroad from U.S. taxation. Foreign income refers to compensation for services performed in another country, and understanding the rules governing it is the first step for any U.S. taxpayer living abroad.

Qualifying for the Foreign Earned Income Exclusion

To be eligible for the Foreign Earned Income Exclusion (FEIE), a taxpayer must first establish that their “tax home” is in a foreign country. A tax home is the general area of your main place of business or employment, regardless of where you maintain your family home. It is the place where you are permanently or indefinitely engaged to work. Having a foreign tax home is a primary requirement that must be met before considering further tests.

Once a foreign tax home is established, the taxpayer must meet one of two tests: the Bona Fide Residence Test or the Physical Presence Test. The Bona Fide Residence Test is a qualitative assessment of a taxpayer’s residency. To meet this test, a U.S. citizen must prove they have been a resident of a foreign country for an uninterrupted period that includes an entire tax year (January 1 to December 31).

The Internal Revenue Service (IRS) looks at factors like the taxpayer’s intentions, the nature and length of their stay, and their integration into the foreign community to determine if the residence is bona fide. Someone who establishes a home, brings their family, and participates in the local culture with the intent to remain for an extended period is more likely to qualify.

The Physical Presence Test is a quantitative measure. To satisfy this test, a U.S. citizen or resident alien must be physically present in a foreign country for at least 330 full days during any consecutive 12-month period. A “full day” is a continuous 24-hour period starting at midnight, and any part of a day spent in the U.S. does not count toward the 330-day requirement. This test depends only on the number of days spent abroad.

Determining Your Excludable Income

After confirming eligibility, the next step is to identify which income qualifies for the exclusion. The benefit applies specifically to “foreign earned income,” which is pay for personal services performed, such as wages, salaries, commissions, and professional fees. The source of the income is determined by where the services are performed, not where the payment is made.

This is different from “unearned income,” which is not eligible for the exclusion and includes items like interest, dividends, capital gains, and pensions. For the 2025 tax year, the maximum amount of foreign earned income that can be excluded is $130,000 per qualifying person. This amount is indexed annually for inflation, and if a taxpayer qualifies for only a portion of the tax year, the exclusion limit must be prorated. For self-employed individuals, the exclusion reduces their income subject to income tax but does not reduce the amount subject to self-employment tax.

The Foreign Housing Exclusion and Deduction

In addition to the FEIE, taxpayers may also be able to exclude or deduct a portion of their housing costs. A taxpayer must qualify for the FEIE to be eligible for this housing relief. The tax code provides the Foreign Housing Exclusion for employees and the Foreign Housing Deduction for self-employed individuals.

Qualified foreign housing expenses are the reasonable costs paid for housing in a foreign country for the taxpayer and their family. These expenses include rent, utilities, renter’s insurance, and parking. The calculation for the exclusion or deduction is based on housing expenses that exceed a “base housing amount,” which is 16% of the maximum FEIE for that year.

For the 2025 tax year, with an FEIE limit of $130,000, the base housing amount is $20,800. There is also an overall limit on housing expenses, which is generally 30% of the maximum FEIE ($39,000 for 2025), but this can be higher for individuals living in designated high-cost localities.

How to Claim the Exclusions

The Foreign Earned Income Exclusion and the Foreign Housing Exclusion/Deduction are not automatic; they must be claimed on a U.S. income tax return. A qualifying taxpayer must file Form 1040 and attach Form 2555, Foreign Earned Income. A return must be filed to claim the exclusion, even if all foreign income is excludable.

If both spouses on a joint return qualify, each must file a separate Form 2555 to claim their respective exclusions. The choice to claim the exclusion is made on a timely filed return and remains in effect for that year and all subsequent years unless it is revoked. Revoking the choice prevents a taxpayer from claiming the exclusion again for the next five tax years without IRS approval. If a taxpayer needs more time to meet the residency tests, they can file Form 2350 to request an extension.

Choosing Between the Exclusion and the Foreign Tax Credit

Taxpayers have a choice between claiming the FEIE and another benefit, the Foreign Tax Credit (FTC). The FTC is a dollar-for-dollar reduction of U.S. income tax liability for income taxes paid to a foreign country. A taxpayer cannot claim both the FEIE and the FTC on the same portion of income.

The FEIE is generally more advantageous for taxpayers living in countries with low or no income taxes. In these situations, there would be little or no foreign tax to credit, making the exclusion the better option. Conversely, the FTC can be more beneficial for those in high-tax countries, as the credit for foreign taxes paid can offset U.S. tax liability more effectively than the exclusion.

Other factors can influence this choice. The FTC, claimed using Form 1116, applies to all types of income, not just earned income, and unused credits can be carried back or forward. For individuals with income above the FEIE limit, it may be possible to use the FEIE on the first portion of their earnings and then claim the FTC on the foreign taxes paid on the remaining, non-excluded income.