Foreign Earned Income
To claim the foreign earned income exclusion or the foreign housing deduction (only when paid from self-employed earnings), you must have foreign earned income. Foreign earned income generally is income you receive for services you perform during a period in which you meet both of the following requirements:
- Your tax home is in a foreign country. (Covered in Part 1 of this series).
- You meet either the bona fide residence test or the physical presence test. (Covered in Part 2 of this series).
As a self-employed professional, your foreign earned income includes your professional fees earned and business profits. The source of your earned income is the place where you perform the services for which you received the income. Foreign earned income is income you receive while working in a foreign country. Where and how you are paid has no effect on the “source” of the income. For example, income you receive for work done in Austria is income from a foreign source even if the income is paid directly to your bank account in the United States.
Royalties received by a writer, author or illustrator are earned income if they are received:
- For the transfer of property rights of the writer in the writer’s product, or
- Under a contract to write a book or series of articles.
Such royalties are reported on Schedule C for the self-employed writer, author or illustrator.
Foreign Earned Income Exclusion
Your foreign earned income exclusion is limited to your foreign earned income minus your foreign housing deduction. You may be able to exclude up to $95,100 in 2012 ($97,600 in 2013) of your foreign earned income. For 2012, you cannot exclude more than the smaller of:
- $95,100, or
- Your foreign earned income for the tax year minus your foreign housing deduction.
EXAMPLE: You are a self-employed professional living and working in a foreign country and meet the bona fide residence or physical presence test. Your net earnings (profit) from self-employment (after all business expenses) shown on Schedule C is $105,000. You are allowed to deduct your foreign housing deduction of $9,084 (see Foreign Housing Deduction Example below) from this amount leaving a balance of $95,916. Of this amount, you would be allowed to exclude $95,100, leaving only a balance of $816 subject to income tax on your U.S. Form 1040. Your personal exemption, allowed on your U.S. Form 1040, would offset this amount.
Foreign Housing Deduction
As a self-employed professional, you are allowed a foreign housing deduction to the extent these expenses were paid for by your self-employment earnings. As with the foreign income exclusion, your tax home must be in a foreign country and you qualify as a bona fide resident or meet the physical presence test.
The Floor and the Ceiling
Your housing amount is the total of your housing expenses (such as rent, utilities, property insurance, rental of furniture and accessories, and residential parking) for the year minus the base housing amount. The computation of the base housing amount is tied to the maximum foreign earned income exclusion. The amount is 16% of the exclusion amount (computed on a daily basis), multiplied by the number of days in your qualifying period that fall within your tax year. For 2012, the maximum foreign earned income exclusion is $95,100 per year; 16% of this amount is $15,216 or $41.57 per day. To figure your base housing amount if you are a calendar-year taxpayer, multiply $41.57 by the number of your qualifying days. Subtract the result from your total housing expenses (up to the applicable limit) to find your foreign housing deduction amount.
Your qualified housing expenses are generally limited to 30% of the maximum foreign earned income exclusion (computed on a daily basis), multiplied by the number of days in your qualifying period that fall within your tax year. For 2012, the standard ceiling would be $28,530 ($95,100 times 30%), or $77.95 per day. If you live in a high-cost locality, you will be allowed a higher ceiling amount. The limits for high-cost localities are listed in the instructions for Form 2555.
EXAMPLE: Your qualifying period includes all of 2012. During the year, you spent $24,300 for your housing. You did not live in a high-cost locality. Since your actual housing expenses do not exceed the standard limit ($28,530), your actual housing costs ($24,300) minus the base housing amount ($15,216), or $9,084, will be your foreign housing deduction.
The housing deduction cannot be more than your foreign earned income minus your foreign earned income exclusion. You can carryover to the next year (and the next year only) any part of your housing deduction that is not allowed because of the limit. Situations involving married couples (both having foreign earned income) or involving separate households in a foreign country or countries will require further computations. This series presents the requirements and benefits for a single, self-employed person.
As a self-employed professional, you will file Form 2555 with your annual return. You are not eligible to use Form 2555-EZ.
In Part 4, the conclusion to this series, I will review where items are reported on your return, discuss how self-employment taxes are handled, and provide some helpful resources.