U.S. citizens and Green Card holders living abroad must pass either the Bona Fide Residence Test or the Physical Presence Test in order to qualify for Foreign Earned Income Exclusion.
Using this exclusion is one of the most popular and legal ways to reduce your tax burden. However, just living overseas doesn’t automatically make you pass either of the tests. In this blog post, we will explain what the Bona Fide Residence Test really is. We will also share with you how to qualify for it and the most common mistakes by U.S. expats make with this test.
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How to Qualify for Bona Fide Residence Test as American living overseas
As we mentioned earlier, sometimes just living abroad isn’t enough to qualify for the Bona Fide Residence Test. Out of two tests, which make you eligible for Foreign Earned Income Exclusion, the Bona Fide Residence test is slightly more complicated. In practice, it gives you more days to spend in the US per year. However, it has more challenging requirements to meet.
So what are the criteria one should pass in order to qualify for it? First of all, you must be a U.S. citizen and not qualify as a U.S. person under the Substantial Presence Test. Else wise, you can be a U.S. resident alien and you are a citizen of a country which has the effective tax treaty with the U.S. Next requirement is establishing a residency in a foreign country for an uninterrupted period of the entire tax year as a minimum. It also means you must be a tax resident there (as long as you are taxed there). And finally, you must have no intentions or plans to move away from the country where you are residing. Yes, it means you don’t think of returning to the US.
Tax Tip #1: Having a domicile (permanent home) abroad isn’t always equal to the residence. The IRS takes into consideration your intentions, purpose of the trip, the nature and length of your stay abroad (The Pub. 54).
The IRS states following regarding Bona Fide Residence Test: “A taxpayer doesn’t automatically acquire bona fide resident status merely by living in a foreign country or countries for 1 year. Under this test, an individual can leave the country for a short period of time, either to the US or elsewhere for the holidays. However, you must prove clear intentions of returning to your foreign residence after such trips.”
Using Foreign Earned Income Exclusion by meeting the Bona Fide Residence Test
What makes you fail a Bona Fide Residence Test? There are few misconceptions regarding rules and requirements to pass this test. Make sure you meet the criteria of the Bona Fide Residence Test. Then you are allowed to use Foreign Earned Income Exclusion on Form 2555.
What a U.S. person for tax purposes needs to remember about the Bona Fide Residence Test:
- You are not a bona fide resident if you submitted a statement to a foreign country’s authorities that you are a non-resident there. And they determine that you’re not a subject to their income tax laws.
- A U.S. expat cannot use both The Bona Fide Residence and Physical Presence tests. You will need to decide which test is easier for you to qualify for.
- American citizen, who moves abroad because a work assignment for a couple of years, will not qualify for this test. All because it was predetermined that he/she will move back to the US after work assignment is over.
- The Bona Fide Residence test doesn’t grant you unlimited time in the US. Moreover, be aware of the Substantial Presence Test which may make you lose your Foreign Earned Income Exclusion.
- Buying a property in a foreign country and spending a few months there will not qualify you as a Bona Fide Resident. Why? Because you still maintain a residence in the U.S.
Tax Tip #2: If you have been a bona fide resident for part of the Tax Year, then you will also qualify as a bona fide resident for that period of time. But this qualification will be put in place when you have already established bona fide residence in a foreign country for an uninterrupted period of the entire tax year. You could qualify as a bona fide resident for a total of an entire tax year plus parts of 1 or 2 other tax years.
What is the difference between the Physical Presence and Bona Fide Residence tests?
The former one requires you to spend at least 330 full days in a foreign country in any 12-month period. Your 12-month period can begin with any day of the month. And it ends the day before the same calendar day, 12 months later. Only 24 consecutive hours starting at midnight count as a full day. However, the 330 days don’t necessarily need to be consecutive. The time you spend on or over international waters doesn’t count toward the 330-day total.
Tax Tip #3: Counting a full day for the Physical Presence Test can be tricky. Remember the following example: you fly from the United States to Spain on August 19th. But you will arrive in Spain on August 20th at 9:00 a.m. only. In this case, your first full day starts on August 21st.
Tax tip #4: The IRS decides whether you qualify as a bona fide resident of a foreign country based on the information you give on Form 2555.
Let’s talk about tax treaties. As we know, there are income tax exemptions provided in such treaties and international agreements. However, this exemption itself cannot prevent you from being a bona fide resident of a foreign country. Instead, you need to take into account all provisions of the treaty or other agreements. Pay attention to ones which are related to residence, privileges, and immunities.
More about exceptions to the test and bona fide residents of Puerto Rico
While using the Physical Presence Test is a straightforward process, it limits the time you can spend in the US. Under this test requirements, you are given 30 days per year to spend in the US. Why do many expats prefer the Bona Fide Residence test? Due to the luxury of spending more than 1 month in the US. You could have a 3-week vacation in California, then come back home for the Christmas holidays. On top of that, you can celebrate Thanksgiving with your extended family and have another holiday in the US mid-summer. As long as you always intend to go back to your country of residence.
There are two exceptions to meeting the minimum time requirements under the Bona Fide Residence Test. The IRS can waive those requirements. Only in cases when you had to leave the country because of war, civil unrest or other unfavourable conditions in that foreign country. However, you will need to prove that if not those disadvantageous circumstances you would have met the minimum time requirements. In such cases, if you figure foreign earned income exclusion or deduction, you will need to include the number of days when you were actually residing or present within the foreign country.
You are not treated as a bona fide resident of a foreign country if you are present there in violation of U.S. law. The only country to which travel restrictions apply now is Cuba.
What about bona fide residents of Puerto Rico? First of all, let’s take a look at who is considered to be Puerto Rico bona fide resident. You must meet the presence test. Secondly, you do not have a tax home outside of Puerto Rico. And last, you do not have a closer connection to other foreign countries or to the United States. Refer to IRS Publication 1321 to determine the special rules for filing U.S. tax returns if you are a bona fide resident of Puerto Rico.
You do not need to file a U.S. tax return if you meet either of the following requirements: 1) You are a bona fide resident of Puerto Rico during the entire tax year; 2) you have income only sourced within Puerto Rico. But if you need to file U.S. federal tax return and claim an exclusion for income earned in Puerto Rico, you will need to adjust your return. If you receive income from sources outside Puerto Rico and/or receive income as a civilian or military employee of the U.S. government in PC, then you must file U.S. tax returns.
Summary of Bona Fide Residence Test for U.S. expats
Using Foreign Earned Income Exclusion is one of the most popular ways to reduce your tax bill. Qualifying for this exclusion isn’t as easy as it seems at first glance. But at the end of the day, it can save you thousands of dollars. Being abroad for an extended period of time doesn’t automatically qualify you for either of the FEIE tests.
Bona Fide Residence test is slightly more complicated than it seems at first glance. The IRS handles the Bona Fide Residence test case-by-case. However, if you are sure you want to use FEIE and you can meet the test, we hope our blog post helped you to gain a better understanding of the requirements. As a U.S. expat, you have to remember a few important things about the Bona Fide Residence test:
- Being present in a foreign country throughout a tax year doesn’t automatically grant you a bona fide resident status.
- You are not allowed to use both tests on your return. The IRS will reject such results and process your return without Foreign Earned Income Exclusion.
- Keeping a home in the US doesn’t always work in your favour if you are trying to pass the Bona Fide Residence Test. Simply because the IRS always takes into account your intentions of being abroad, the nature of the length of the trip.
Would you like to have professional tax advice on your tax situation, including Bona Fide Residence test requirements? In over 7 years we have helped over thousands of U.S. expats. We file your U.S. tax returns and save money on your tax bills. Do not hesitate to contact us and book a consultation with our U.S. tax experts.