We’ve all thought it… Sitting on the beach in a tropical place while attending a quick meeting via your laptop before hitting the waves in the afternoon sun. Many people imagine that all they must do is get a work Visa, wave good-bye to family and friends and head to sunnier shores for a bit. Before you jump ship, or hop a plane, there are important tax items to take into consideration. The Internal Revenue Service will not ignore you just because you live in a remote village on a Fijian island. United States citizens (and resident aliens) for the most part, are subject to federal income tax on all worldwide income. There are a few ways to exclude some up to all of that income, depending on what you earn and how far you are willing to go to make that income not taxable to the federal government.
The first and easiest method is the Foreign Earned Income Exclusion. This allows a qualified individual to exclude up to $104,100 (in 2018) of previously taxable earned income. Earned income is defined by the IRS as taxable wages and employee pay, certain disability or union benefits, and net earnings from self-employment. This means that you cannot exclude income from interest and dividends, capital gains, retirement account distributions, Social Security, unemployment, passive rental income, alimony or child support. This income will still be reportable and potentially taxed regardless of if you meant the Foreign Earned Income Exclusion requirements.
The first requirement for the Foreign Earned Income Exclusion is that you must reside and work outside of the United States. Additionally you must also meet the Physical Presence Test or Bona Fide Residence Test. The Physical Presence Test requirements are that you must be physically present in a foreign country for three-hundred-and-thirty non-consecutive full days (24 hours) during a twelve-month period. You do not have to be in the same foreign country for the entire period. However, international waters do not count. It is also crucial to make sure you are fully out of United States airspace when you begin your twenty-four hour count. One advantage is that because the twelve-month period can consist of any uninterrupted twelve-month period, it can overlap years. This can bring on the extra challenge of filing for and planning for the Physical Presence Test at times. The three-hundred-and-thirty-day requirement also greatly limits the number of days you can return to the States. Some people have gone as far as to break as many ties as possible with the United States and their residency terms in order to show physical presence. This can mean being as extreme as giving up your house, apartment and/or office, disposal of your vehicle and ceasing the use of any storage facility. This creates room for the Bona Fide Residence Test.
The Bona Fide Residence Test states that you must be a resident of the foreign country for an uninterrupted period that is an entire tax year. This is different than the Physical Presence Test in that in must be for a calendar year, thereby eliminating the ability to choose the twelve-month period that brings you the biggest chance for the exclusion. Additionally, the term resident carries a different meaning than physical presence. You must set up permanent housing in the foreign country, even if you intend to return to your home in the United States at some point in the future. This does not mean that you must purchase a home in the foreign country, as a long-term lease also qualifies. You must at no time during the year make any statement that you are not a resident of the foreign country, nor can you avoid paying taxes in that country if you qualify for their thresholds. Many factors go into qualifying for the Bona Fide Residence Test, and often those are made at the time of the filing of your annual federal return. Additionally, if you are married, moving the spouse or family there can often aid in your position, although it is not required. And while you can travel on vacations, they must be short, and intentional.
If you meet the Physical Presence Test or the Bona Fide Residence Test, there is an additional component of possible tax savings called the Foreign Housing Exclusion. This allows you to potentially deduct a portion of your housing costs related to your foreign residence. The Foreign Housing Exclusion requires that you utilize employer-provided funds. This does not mean that the employer must pay for the housing. It simply means that the funds used must be traced back to the employer and not say a pre-established savings account. Housing in this case includes rent, fair rental value of housing provided in kind by your employer, repairs, certain utilities, insurance, parking and other similar items. It does not include extravagant items such as domestic labor, or improvements to the property, property taxes or interest. The deductible portion of this is only the amount that is over and above the base housing amount. The base housing amount is sixteen percent of the maximum foreign earned income exclusion for the year. It is important to note that your foreign earned income will be reduced by your Foreign Housing Exclusion. This means that there are times that the Foreign Housing Exclusion may not be beneficial, such as if your total foreign income is close to the sixteen percent non-deductible base housing amount. There are also limits to how much of your housing may be deductible. So this plays an important factor in the calculation of possible taxable income deductions.
It is also important to determine what the taxation rules are of the country you intent to reside in. Generally, if you spend more than one-hundred-and eighty-three days in another country, you are considered to be a fiscal resident of that country. If you are aiming to utilize the Physical Presence Test and move from country to country, the likelihood that you will fall into the fiscal residence category is fairly small. However, if you intend to qualify under the Bona Fide Residence Test, things will get a bit harder. Some countries have high tax rates while others have low rates and still other have no taxes at all. Choosing a country with the best tax treatment may not always be possible or preferable. Additionally, the rule of thumb surrounding the one-hundred-and-eighty-three-days does not hold true for all countries. It is important to research each potential location prior to moving. Seeking the advice of a tax professional prior to packing your bags with a one-way ticket in hand is also advisable.