U.S. Citizens Living and Working Abroad
If you are a U.S. citizen living and working abroad, you face potential tax implications.
The United States has a taxation system that requires its citizens to report and potentially pay taxes on their worldwide income. In other words, as a U.S. citizen, you remain subject to U.S. tax obligations, even when living abroad.
Overview
As a U.S. citizen living and working in any foreign country, you can take advantage of three possible income tax breaks:
- The foreign earned income exclusion allows you to exclude up to $120,000 of your foreign income from federal income taxes.
- The housing exclusion (or deduction) allows you to exclude or deduct up to a ceiling amount of certain foreign housing costs, including rent, utilities (except telephone), and real and personal property insurance.
- The foreign tax credit allows you to reduce your taxes by the taxes you paid in the non-U.S. country where you The foreign tax credit’s purpose is to eliminate double taxation of foreign earned income. You can’t use the foreign tax credit on income you excluded using 1 and 2 above.
Foreign Earned Income Exclusion
As a U.S. citizen living and working in a foreign country, you may be eligible for the foreign earned income exclusion. This provision or deduction allows you to exclude from your U.S. taxable income a portion of the wages you earned abroad.
What Is Foreign Earned Income?
“Earned income” is money you earn for personal services performed, such as wages, salaries, or professional fees. So, “foreign earned income” is the money you earn during the period that you live abroad. To qualify for the foreign earned income exclusion, you need to have a tax home in a foreign country and to meet one of the two residency requirements discussed below.1
If you qualify, you can avoid federal income taxes on up to $120,000 of your 2023 earned income.2 Both wage and self-employment income can qualify for the “living abroad” tax breaks.
And if you’re married and both you and your spouse have income from living abroad, each of you can qualify for these tax breaks.
Tax Home in a Foreign Country
Your “tax home” (despite how it sounds) is not necessarily the physical home in which you live but is located at your regular place of business.3 For tax-free income, you want that location to be in a foreign country.
If you have no regular or principal place of business because of the nature of your work, then your “regular place of abode” (your residence) is the location of your tax home.4
During any period that your abode is in the United States, you lose your foreign-located tax home.5
The Two Residency Tests
Two primary factors determine residency overseas. One is the physical presence test, and the other is the bona fide residence test. Let’s use Germany as our example.
The physical presence test. If you have met Germany’s residency requirements, then your home is in Germany. You cannot establish residency in any other country.
To qualify for the foreign earned income exclusion, the U.S. requires that you reside in Germany for 330 days within a 12-month period.6 The 330 days do not have to be consecutive days. This affords you 35 days to vacation, live, or work as a non-resident anywhere else in the world.
If the 12-month period is from January 1 to December 31, you may take a full “exclusion” of up to $120,000 for 2023.7
If the 12-month period overlaps partially with the previous tax year, you can prorate your exclusion.8
Example. You move to Germany, and your first full day there is July 1, 2023. You meet the physical presence test for the period July 1, 2023, to June 30, 2024; therefore, the maximum exclusion you can take in 2023 is $60,000 (50 percent of $120,000).
The bona fide residence test. This test is not as desirable; you can rely on it only if you can’t meet the physical presence test. Under the bona fide residence test, you must live abroad for the entire tax year. Also, your residency must be on consecutive days. There are no days allowed for living or working in other countries.9
Please note, unlike meeting the physical presence test, meeting the bona fide residence test does not give you a prorated exclusion for your first partial year.
In order for you to pass the residency test, courts take many factors into account, including the following:10
- The taxpayer’s Is it your intention to stay in Germany where you live and work?
- Establishment of a Have you signed a lease or purchased a house in Germany?
- Location of Is your family living with you?
- Nature and duration of Do you have a contract with a German company for an extended period of time?
- Social and economic ties to the foreign country. Do you have extended family or friends in Germany?
Note: If you live abroad, you need to proactively structure your time back in the United States so that you meet the 330-day physical presence test in a calendar-year period. This ensures German residency using the safer of the two tests.
Collect the Money
Here’s a caution: to qualify for the income exclusion, you need to collect the money you earned before the end of the taxable year that follows the year in which you performed the services.11
Example. You earned the money in 2023. You need to collect the money before 2025.
NOTE: You can’t structure the pay to trigger the exclusion in the second or later year after the year you earned the money. The purpose of this rule is to limit manipulative efforts to enable the exclusion and avoid foreign taxes.
Foreign Housing Exclusion or Deduction
Want more than $120,000 of tax-free income? You can claim an additional exclusion for the cost of housing. Here’s how it works:
- Add up the expenses that qualify for the exclusion, which include rent, the fair rental value of employer-provided housing, utilities (but not telephone charges), insurance, furniture rental, repairs, and parking.12
- Take 16 percent of the $120,000 exclusion for 2023 ($19,200) and subtract it from your housing costs above.
- Claim no more than 30 percent of the $120,000 exclusion ($36,000).13
The actual computation is done daily, but what you see above gives you the basics.
Example. Say your qualified housing costs while living in Germany for the year are $60,000. Subtract $19,200 for the base housing amount, and you have $40,800. But the most you can deduct is $36,000, so your foreign housing exclusion or deduction is $36,000.
Expenses that don’t qualify for the exclusion include capital expenditures (such as the purchase of a house), mortgage interest and real estate taxes on a house you own, purchased furniture, domestic labor, television subscriptions, and deductible moving expenses.14
How Do You Take the Exclusions?
For the first taxable year for which you want to claim the foreign earned income exclusion or the foreign housing exclusion, you must elect it using IRS Form 2555; the election is valid for all subsequent years unless revoked.15
The Form 2555 election is an individual election. If spouses are claiming the exclusion for the first time on a joint return, each spouse must complete a Form 2555.
Foreign Tax Credit
Most foreign countries impose an income tax. So, you will most likely pay income taxes to the country in which you’re living and working. If you were sent to Germany, then you will pay taxes in Germany.
The United States taxes your worldwide income but allows you to minimize or even eliminate double taxation. You can do this by taking advantage of
- the foreign earned income exclusion and the housing exclusion or deduction, as discussed above or
- the foreign tax 16
As a U.S. citizen, in situations where you pay income taxes to a foreign country, often you can claim a foreign tax credit. This allows you to avoid double taxation by reducing your U.S. tax liability by the amount of foreign taxes paid on the same income.
It’s important to note that certain rules and limitations apply when claiming the foreign tax credit.
You may not claim both the foreign tax credit and the foreign earned income exclusion or the housing exclusion/deduction on the same income17. So, you must decide which of the two tax breaks gives you the better benefit.
Here is some information that will help you decide.
If you live and work abroad and you pay income taxes to a foreign country, you might end up in a better position by electing the foreign tax credit to offset your U.S. tax liability.
Also, there are several benefits to using the foreign tax credit over the foreign earned income exclusion.
Benefits of Using the Foreign Tax Credit
Here’s one advantage to using the foreign tax credit: if you can’t use the entire foreign tax credit amount in the current year due to limitations, you can carry any unused amounts back one year and, if not used, then forward for up to 10 years.18
If you elect to take the foreign earned income exclusion, you can’t get the additional child tax credit for that year.19 But if you use the foreign tax credit and you have dependent children living with you in Germany, the additional child tax credit could still be refundable assuming you do not have U.S. tax liability.20
Here’s another advantage to using the foreign tax credit: once you elect the foreign earned income exclusion, you must continue to use it unless you specifically revoke it. And once the foreign earned income exclusion is revoked, you cannot reelect it during the next five tax years unless you get consent from the IRS via a private letter ruling (generally an expensive option).21
Reporting Foreign Financial Accounts
As a U.S. citizen living in Germany, you will likely have some German bank accounts. You need to be aware of your reporting obligations regarding foreign financial accounts.
If the total combined value of all your foreign bank and financial accounts exceeds $10,000 at any time during the year, you’re required to file the Report of Foreign Bank and Financial Accounts (FBAR).22
You may also need to disclose additional information on Form 8938, Statement of Specified Foreign Financial Assets.
Tax Treaties
You’ll be interested to know that the United States has income tax treaties with many countries.23 Such treaties can impact your tax obligations. Treaties like these exist for various reasons, but mainly to prevent double taxation by promoting cooperation between countries in tax matters.
Under these treaties, you may be eligible for certain credits, deductions, exemptions, and reductions in the rate of taxes on certain items of income you receive outside the U.S.
Social Security
International agreements (known as “totalization agreements”) eliminate dual taxation on Social Security and Medicare taxes.
The United States has entered into such agreements with 25 foreign countries. Totalization agreements exempt wages from Federal Insurance Contributions Act (FICA) taxes.
This is a beneficial tax break if your earnings are subject to taxes or contributions for similar purposes under the social security system of a foreign country. A similar exemption exists if you are self-employed.
Key point. You cannot use the social security taxes paid to a foreign country as taxes paid for the foreign tax credit due to a totalization agreement, because such an agreement eliminates the double-taxation threat.
Takeaways
As a U.S. citizen, you report and potentially pay taxes on your worldwide income, regardless of where you reside. In this article you were sent to Germany and triggered the possible use of either
- the combined foreign earned income exclusion and housing exclusion/deduction, or
- the foreign tax
The foreign earned income exclusion permits you (as a U.S. citizen) to exclude up to $120,000 of your foreign earned income from federal taxes. To qualify, you need to have a tax home in Germany and meet one of two residency requirements, which involve staying in Germany for a certain duration.
The housing exclusion or deduction allows you to exclude or deduct certain foreign housing costs.
Alternatively, you can claim a foreign tax credit, which can reduce your U.S. tax liability by the amount of foreign taxes you paid to Germany. The foreign tax credit allows you to avoid double taxation. But you cannot claim, on the same income, both the foreign tax credit and the foreign earned income or housing exclusion/deduction.
The foreign tax credit has advantages over the foreign earned income exclusion because the foreign tax credit gives you —
- the ability to carry back one year (and forward for up to 10 years) unused amounts,
- eligibility for the additional child tax credit, and
- the possibility of revoking the decision (in contrast to the irrevocability of the foreign earned income exclusion).
Footnotes
- IRC Section 911(b)(1)(A).
- Rev. Proc. 2022-38; IRC Sections 911(b)(2)(D); 911(a).
- Section 1.911-2(b).
- ibid
- ibid
- Section 1.911-2(d)
- Section 1.911-3(d).
- ibid
- IRC Section 911(d)(1)(A).
- Nelson v , 30 T.C. 1151; Benfer v Commr., 45 T.C. 277 (1965); Larsen v Commr., 23 T.C. 599 (1955).
- IRC Section 911(b)(1)(B)(iv).
- Section 1.911-4(b)(1).
- IRC Section 911(c).
- Section 1.911-4(b)(2).
- Section 1.911-7(a)(1); IRS Form 2555, Foreign Earned Income (2022); Instructions for Form 2555, dated June 29, 2022.
- IRC Section 911.
- IRC Section 911(d)(6).
- IRC Section 904(c).
- IRC Section 24(d)(3).
- IRC Section 24(d).
- IRC Section 911(e)(2).
- The FBAR report is authorized by 31 S.C. Section 5314.
- IRS 901, U.S. Tax Treaties (2016), dated Oct. 12, 2016, p. 2.