To use the Foreign Earned Income Exclusion, you need to pass either the Physical Presence or Bona Fide Residence Tests.
As an American abroad, for 2018 tax year you could exclude up to $104,100 by using this exclusion. As well as you can take advantage of foreign housing deduction. In this blog post, we cover the Physical Presence Test and its requirements. While it seems quite straightforward on the surface, this test has its own pitfalls. And we will share which ones U.S. citizens abroad should know about. Let’s take a deeper look at the Physical Presence Test requirements. And learn how to pass it in order to use Foreign Earned Income Exclusion.
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What is the Physical Presence Test and how to qualify for it?
The Physical Presence test requires you to be out of the United States for 330 days minimum in a period of 12 consecutive months. However, the 330 qualifying days do not need to be back-to-back. Being present in a foreign country doesn’t mean that you have to be there for employment purposes. You can be on holiday or for other private reasons.
To meet the requirements of the Physical Presence Test, you must be:
- a U.S. person (filing Form 1040),
- be in a foreign country for 330 days out of any 12-month period,
- and not in violation of an embargo (unauthorized travel to Cuba). Additionally, any income you earn from sources within a country where you were present in violation of U.S. laws, doesn’t qualify as foreign earned income.
Tax tip #1: Both U.S. citizens and resident aliens can use Foreign Earned Income Exclusion. To this Physical Presence Test, it’s doesn’t matter why you are staying abroad. However, any family emergencies, being ill or employer’s directive do not serve as valid reasons to allow for exclusion if you spent less than 330 days.
What is a full day when it comes to the Physical Presence Test? The IRS counts a full day as 24 consecutive hours starting at midnight. A taxpayer has to spend each of the 330 days in a foreign country, In cases, when you are travelling to a foreign country or coming back to the United States, the time you spend on or over international waters is not taking into the total number of 330 days.
How to count the 12-month period for the Physical Presence Test?
There are a few crucial rules to keep in mind about this test. What happens if you are in transit between two different places outside the United States and you are physically present in the US for less than 24 hours? In such cases, you are treated as travelling over areas not within any foreign country. Now, to figure 12-month period for the Physical Presence test you better remember the following rules:
- Your 12-month period can start with any day of the month. And it will end exactly 12 months later the day before the same calendar day.
- The 12-month period has to be consecutive months. And if you spend 330 days in a foreign country or countries within that period, you can use it.
- You are free to choose the 12-month period which gives you the greatest exclusion. It means you are obligated to neither start your 12-month period with your first full day abroad. Nor end it with the exact day of you leaving a foreign country.
- The 12-month period can overlap one another when you are determining whether the 12-month period falls pithing a longer stay in a foreign country.
Tax Tip #2: What if you work in a foreign country from time to time? For example, if you are a construction worker in a foreign country and you are present there for certain periods of time over a 20-month period. You can pick any period of 330 full days in the 12-month consecutive period. Usually, that would be the middle months when you were working in a foreign country. That way you can pass Physical Presence Test.
Can U.S. citizens and Green Card holders move places? Yes, and you can relocate from one foreign country to another without losing full days for the Physical Presence Test. It can be a little bit tricky with the next clause of the rule. You lose full days if any part of your travel is not within a foreign country or countries and it takes 24 hours or more.
Tax tip #3: Examples of the above-mentioned rule shows that if you leave Portugal by ship at 9:00 a.m. on September 12th and arrive in Norway at 7:00 a.m. on September 14th, 2 days later. With respect to the rules, you will lose September 12th, 13th and 14th as full days.
Tax tip #4: The IRS can waive minimum time requirements if you should leave a foreign country because of war, civil unrest, or similar adverse conditions in that country. However, you have to prove that you reasonably could have expected to meet the minimum time requirements if not for the harmful conditions.
Examples of the Physical Presence Test situations will help you to better understand the requirements and how to count days. 1st case: a U.S. citizen, let’s call him Andy, moved for business to Berlin, Germany on August 15th, 2017. He stayed there until July 26th, 2018. Andy stayed abroad for 345 days, he meets the requirements of the Physical Presence Test. What if Andy didn’t travel to the US or its territories during those 345 days? Well, he would still pass the test. But if he visited the U.S. for 15 days or more, he no longer qualifies for Foreign Earned Income exclusion under the Physical Presence Test.
Why is it easier to qualify for the Physical Presence and not the Bona Fide Residence Test? The latter one is decided by the IRS case-by-case. All due to the fact that they take into consideration the intention, purpose, nature and length of the trip abroad. As a bona fide resident of a foreign country, you must have no intentions of returning to live in the US at any time in future. You also must be a tax resident in a foreign country for a full calendar year. While the Physical Presence test only requires you to be out of the US for 330 days within a 365-day period. And they don’t question the nature of your stay overseas!
It’s important to note that you cannot use both tests to qualify for Foreign Earned Income Exclusion. You must choose to either use the Physical Presence Test or Bona Fide Residence Test. However, you can switch from the former test to the latter. For example, if you acquire a tax residency in a foreign country, hold that status for a full calendar year and have no plans to return to the US.
The tax year doesn’t change if you are using the Physical Presence Test. Instead, you will report your income earned during the tax year. And then claim the exclusion for the days that fall within that period.
Summary of the Physical Presence Test for U.S. expats
Moving abroad as a U.S. citizen or Green Card holder isn’t easy. On top of it, you have U.S. tax obligations regardless of where you live. While Uncle Sam gives you options to reduce your tax owing, it comes with different limitations. If you want to exclude your foreign earned income by using the available exclusions and deductions, you will first need to pass one of the 2 tests to qualify. And given that you have a tax home abroad. According to the IRS, the tax home is where you work permanently or indefinitely. If you have abode or tax home within the US, you fail the tax home test and don’t qualify for the Foreign Earned Income Exclusion.
If you don’t plan to spend more than 35 days in the US per 12-month period, then it will be easy for you to meet the requirements for the Physical Presence Test. The Physical Presence Test is based on the total number of days you spend in a foreign country. It doesn’t take into account the kind of residence your establish, intentions about you returning to the US, etc., which is completely opposite to Bona Fide Residence Test requirements.
To use Foreign Earned Income Exclusion, you will need to file Form 2555 together with Form 1040. You will need to report information for the Physical Presence Test on Part III, Taxpayers Qualifying Under Physical Presence Test of Form 2555. Our professional team of tax experts specializes in U.S. international taxation for Americans living overseas. We help U.S. expats to reduce their tax owing and stay compliant with their U.S. taxes. Contact us now if you want to discuss your tax situation and have us prepare, amend or review your U.S. tax return.