For American expats, the experience of living and working abroad comes with various financial considerations, including taxes. One such consideration is the Foreign Housing Exclusion (FHE), a provision in the United States tax code that relieves expats who incur housing expenses while residing in a foreign country. We have listed below the key aspects of the Foreign Housing Exclusion and its implications for American expats.
What is the Foreign Housing Exclusion?
The Foreign Housing Exclusion is a provision in the US tax code that allows eligible American expats to exclude a portion of their foreign housing expenses from their taxable income. In simpler terms, it provides a tax benefit by reducing the money you owe in taxes based on the housing expenses incurred while residing in a foreign country.
Who Qualifies for the Foreign Housing Exclusion?
First, you must be a US citizen or a resident alien. Second, you must have a “tax home” in a foreign country and meet either the “bona fide residence” test or the “physical presence” test.
The Bona Fide Residence (BFR) test focuses on your intention to establish and maintain a bona fide residence in a foreign country. It requires you to demonstrate that you have taken up residence in the foreign country and genuinely intend to make it your home for an extended period.
Critical Factors of the Bona Fide Residence Test
- Length of Stay: The IRS does not specify a minimum duration of residence to meet the bona fide residence test. However, it generally requires a significant period of time, typically a full tax year or longer. The longer your stay, the stronger your case for establishing a bona fide residence.
- Intent: Your intention to establish a bona fide residence is crucial. Factors contributing to proving intent include maintaining a permanent home, establishing local ties (such as bank accounts, memberships, or community involvement), and demonstrating a lifestyle consistent with a settled residence.
- Tax Home: The concept of a “tax home” is important in determining eligibility for the FHE. Your tax home is your regular place of business, employment, or post of duty, regardless of where your family home is located.
It’s important to note that the bona fide residence test is subjective and requires a case-by-case evaluation. The IRS looks at various factors to determine whether you have established a residence in a foreign country and intend to make it your home.
Meanwhile, the Physical Presence Test (PPT) focuses on the number of days you are physically present in a foreign country during a specified period. It is designed to determine whether you have spent significant time in a foreign country to qualify for the FHE.
Key Factors of the Physical Presence Test:
- 330-Day Requirement: To meet the physical presence test, you must be physically present in a foreign country or countries for at least 330 full days during any consecutive 12-month period. The 12-month period can begin on any day of the year and does not have to align with the calendar year.
- Counting Days: A full day is considered any part of a day where you are present in a foreign country. It does not necessarily require you to be present for 24 hours. Even brief trips or layovers in the US counts as days of presence in the United States, not in the foreign country.
- Temporary Absences: Temporary trips outside the foreign country, such as vacations, business trips, or medical treatment, do not interrupt the 330-day count. However, these trips must be reasonably expected and incidental to your presence in the foreign country.
- Maintenance of Tax Home: While meeting the physical presence test, you must maintain your tax home in a foreign country.
It’s important to note that the physical presence test is objective and based solely on the number of days physically present in a foreign country. It does not require establishing a bona fide residence or demonstrating intent to make the foreign country your home.
Calculating the Exclusion
The Foreign Housing Exclusion allows you to exclude a certain amount from your taxable income based on a calculation involving the foreign earned income exclusion (FEIE). The FEIE for tax year 2022 is $112,000, meaning you can exclude this amount from your total foreign earned income.
However, the housing exclusion is subject to certain limitations. The exclusion is based on the higher of two amounts: either the actual housing expenses incurred or a standard limit set by the IRS. Generally, the limitation on housing expenses is 30% of the maximum foreign-earned income exclusion. Nevertheless, the standard limits vary depending on the location of your foreign residence. The limit intends to reflect the differences in housing costs between countries and regions. You may be eligible for a higher exclusion if your housing expenses exceed the standard limit.
Important Considerations
While the Foreign Housing Exclusion provides a significant tax advantage for American expats, there are a few important factors to consider:
- Documentation: It is crucial to maintain accurate records of your housing expenses, including receipts, lease agreements, and utility bills. This documentation will be necessary to support your claim for the exclusion in case of an audit.
- Currency Conversion: You must convert your foreign housing expenses into US dollars for tax purposes. The conversion should be done using the appropriate exchange rate for each transaction or the average rate for the tax year.
- Tax Treaty Considerations: Some countries have tax treaties with the United States that may affect your eligibility for the Foreign Housing Exclusion. It is advisable to consult a tax professional or refer to the specific tax treaty provisions to understand potential impacts.
- Filing Requirements: To claim the Foreign Housing Exclusion, you must file a US tax return, typically Form 2555 or Form 2555-EZ, along with the necessary supporting documentation. You cannot claim the exclusion on Form 1040EZ.
Understanding and utilizing the Foreign Housing Exclusion can result in significant tax savings while living and working abroad. By meeting the eligibility criteria and keeping accurate records of housing expenses, expats can reduce their taxable income and effectively manage their tax liabilities.
If you need help claiming the Foreign Housing Exclusion on your US tax return, feel free to contact us at info@universaltaxprofessionals.com.
