Digital Nomads using the Foreign Earned Income Exclusion while traveling the world is an important benefit that shouldn’t be ignored.
As a Digital Nomad, you’re probably aware of the Foreign Earned Income Exclusion. Logically, if you aren’t living in the US why would you pay tax to the IRS? Why would you pay tax to your home state? With regards to making an income, when you are in the USA, the state you are in determines to whom you pay tax.
Unfortunately, it doesn’t work that way. As a US citizen with income, you will be required to file a federal return. You may even need to file a state return!
With that said, it’s not all bad news. While it stinks that you have to file a federal return, you can exclude up to $122,000 (in 2023) of income from being taxed on your federal return
Let’s learn about the Foreign Earned Income Exclusion AND the Foreign Housing Deduction saves money for Digital Nomads. Simply put, let’s save you a lot of money.
Understanding the Foreign Earned Income Exclusion (FEIE)**
Digital nomads need to have a clear understanding of the Federal Earned Income Exclusion to properly take advantage of its benefits. Let’s take a deep dive into the FEIE and how it can help you.
This is what the Foreign Earned Income Exclusion is.
The Foreign Earned Income Exclusion is exactly what it sounds like. It’s the perfect tool for a Digital Nomad. It allows you to EXCLUDE $122,000 (This is the 2023 amount which will index every year) from your tax calculations on your federal return. Unfortunately, you will be liable for self-employment tax. To report the FEIE and the Foreign Housing deduction, use IRS form 2555.
There are 2 ways to qualify as a US citizen. They are:
- A US citizen or resident alien who is physically present in a foreign country (or countries) for at least 330 days of any 12-month period (must be consecutive months). Time spent in Cuba (a violation of US travel restrictions) does not count towards the 330 days.
- A US citizen who is a bona fide resident of a foreign country (or countries) for an uninterrupted period that included an entire tax year.
- A third qualifier is only available if you are a US Resident alien who is also a citizen of a country with which the US has an income tax treaty in effect and who has been a bona fide resident of a foreign county (or countries) for an uninterrupted period that includes a full tax year.
How About the Foreign Housing Exclusion/Deduction?
You read that right. Under certain circumstances you can write off, or exclude certain occupancy costs. So how can you qualify for the Foreign Housing Exclusion!?
The first step is for the Digital Nomad to qualify for the Foreign Earned Income Exclusion. To qualify for the Foreign Housing Exclusion, you must either:
- Be a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year, or;
- You must have been physically present in a foreign country for 330 or more full days over a twelve-month period. This period can be over two tax years.
- As an example, you moved to Mexico on Jun 1, 2022. You can extend your return until the Oct 15 filing date next year and use 5 months in 2023 as your 12-month period. This will give you 12 consecutive months to qualify, even though you were only in the country for 7 months of the tax year in question.
Once you pass one of these qualifications, the next step is to calculate a possible deduction. To do this, you must know what expenses are allowed. They are:
- Rent for an apartment, condo or house in a foreign country.
- All utilities paid except for phone and internet (you’ll take part on your Schedule C reporting yourself employment income).
- Renters insurance.
- Any leasing fees that may be charged. One of the things I’ve noticed while researching foreign countries is that many of them treat foreigners differently and will be charged accordingly. This means more.
- If you had to rent furniture, this is deductible.
- If you had to pay for parking by your residence, this would also qualify.
- Under certain circumstances, repairs made to the rental property are deductible.
If you’ve qualified for the FEIE as a Digital Nomad, your chances to qualify for the Foreign Housing deduction is good.
Once you’ve gathered all the info you’ll need, we can calculate your potential deduction. Your location will determine the actual amount.
After collecting all of your qualified housing expenses you must find the max allowed by the IRS based on your locale. For example, Moscow in 2022 would have allowed a $107,000 housing deduction. Barcelona would allow a $40,600 deduction. These maxes are based on the actual cost of housing in that area, hence the differences. If your locale isn’t located on the chart, your max will be $36,000 in 2023.
After collecting all of your information the actual calculation is simple. The equation is:
(FEIE amount x 30%) – (FEIE amount x 16%) = Amount deductible.
The annual limits change annually to index for inflation but the equation remains unchanged.
Using the above formula and assuming your max allowable is $36,000, you would be able to deduct in 2023:
($120,000 x 30%) – ($120,000 x 16%) = X
($36,000) – ($19,200) = $16,800
Your housing exclusion would be $16,800. This is the full tax year deduction and is calculated using annual amounts.
The reason for the disparate limits could help if you are travelling and in different cities throughout the tax year. In this case, you would calculate your housing exclusion using the daily limits.
Let’s do one where you spent 183 days in Bermuda and 182 days in Hua Hin Thailand. Bermuda has a $246.58 daily rate. Hua Hin has a default rate of $98.63.
Your calculation would be:
((246.58 x 183) + (98.63 x 182) – (120,000×16%) = X
(45,124.14 + 17,950.66) – (19,200) = X
(63,074.80) – (19,200) = 43,874.80
In this example your maximum housing deduction would be $43,875. If you spent less than the max allowable, you would take that into consideration. If your actual expense was $40k for Bermuda and $15k for Hua Hin, the amount paid is $55k which is less than the calculated amount.
Your allowable deduction would be 55,000 – 19,200 = 35,800. $35,800 would be your allowable housing deduction.
You Qualify as a Digital Nomad for the FEIE. Now what?
As mentioned earlier, you needed to keep not just good, but great records. Collect your records. They should be:
- Full days spent in a country. Travel days are considered US days. Driving from one country to another doesn’t count towards either country. It is considered a USA day.
- As a Digital Nomad trying to qualify for the FEIE, you must keep a set of books. This should include a balance sheet and profit and loss statement.
- You should be tracking your qualified housing expenses. Qualified expenses are:
- Rent and utilities.
- Renters insurance and leasing fees.
- Rent paid for furniture and parking spots.
- Repairs to the rental.
- Purchasing a house or furniture does not qualify.
- Lavish expenses do not qualify (like servants)
Once you have collected all the necessary records, you’re ready to get them to your tax preparer. I would like a Zoom appointment to go over all your info and to answer questions you or the tax pro may have.
Potential Problems and Issues to Consider
The Foreign Earned Income Exclusion is an AWESOME tool that can save you $1,000’s in tax. Even though, a Digital Nomad must be aware of potential problems, specifically tax treaty and social security totalization agreement implications.
A tax treaty is an agreement between the US and a foreign country as to the treatment of tax and income related items between the two countries. Without a tax treaty with the US, you may be required to pay tax on the same income twice with no available foreign tax credit.
If there’ a social security totalization agreement in place between the US and the foreign country, then you won’t be required to make social security contributions on the same income to two countries. Absent this agreement, you will be responsible for paying into two systems in two countries. And since they aren’t income tax payments, they will not qualify for the foreign tax credit.
Now You Get to Mix and Match
Due to the complexity of the Foreign Earned income Exclusion and the Foreign Housing Deduction, plus the Foreign Tax Credit (based on any income tax paid to the foreign entity, I strongly advise you to hire a tax professional with experience in expat (and digital nomad) taxpayers.
With so many options available to help reduce your tax, you must make sure to only take what you qualify for. As an example, you can’t take a foreign tax credit on income you excluded via the Foreign Earned Income Exclusion.
Depending on the complexity of your combined returns and any tax treaties and agreements between the country you are in and the US (federal, possible state and foreign country), there are tax issues you may or may not be party to.
A lot comes down to the treaty and/or agreement the US has with your foreign country.
Conclusion to Digital Nomads And the FEIE
If you are a Digital Nomad living in a foreign country you must learn about the Foreign Earned Income Exclusion, and the Foreign Housing Deduction.
The Foreign Earned Income Exclusion will reduce your federal income tax liability. It does not reduce your self-employment tax.
The Foreign Housing deduction will generally allow a housing deduction of $16,800, but if you are living in a high-cost area such as Hong Kong, the allowable deduction could be as much as $95,100.
You should keep detailed records regarding full days at a specific location. Travel days are considered days spent in the US (they give you 35 travel days per year).
There are two primary ways for a Digital Nomad qualify for the Foreign Earned Income Exclusion:
- If you live in a country for 365 uninterrupted days in a foreign country that includes a full tax year, then you are a Bona Fide resident and qualify.
- If you lived in a foreign country for 330 days in a 12 consecutive month period, then you also qualify. You can extend your filing date into the next tax year if you don’t have 12 consecutive months in the tax year in question.
You must be careful when utilizing these US benefits given to US citizens working in foreign countries. The ability to take advantage of these benefits is predicated on the tax treaties and the social security utilization agreements between the US and various foreign countries.
All in all, a layperson (which is what most Digital Nomads are) will have difficulty with the Foreign Earned Income Exclusion calculations and qualifications required. I advise you to find a tax pro versed in expat taxation.
That’s it for today folks. Thanks for everything and hot me up with questions if you have any.
Stay cool.
JKC
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