Foreign earned income and Form 2555

We prepare a couple of these every year, and every year the conversation is the same. The client knows about the exclusion. What the client does not know is that the United States taxes its citizens on the whole world, that the excluded pay does not disappear from the arithmetic, and that the house they kept in Colorado can be the thing that disqualifies them. Here is how it works, start to finish.

Why the U.S. taxes you at all

Nearly every other country taxes people who live there. The United States taxes people who are American, wherever they live. A citizen working in Germany for a German employer, paying German tax, still owes the IRS a return on that income, and would owe U.S. tax on it too if the law stopped there. The exclusion exists so that it does not. Congress put it in the Code in 1926, two years after the income tax started reaching overseas pay, on the theory that Americans working abroad should be able to compete for those jobs without carrying two countries’ taxes. It has been rewritten several times since — most recently in 2006, which is where the catch below comes from — but the idea is unchanged: the first $130,000 or so of what you earn by working in a foreign country is yours, U.S.-tax-free.

The exclusion is not automatic. You claim it by filing Form 2555 with your return, and once you claim it you are treated as having elected it for every later year until you revoke it. Revoking it is easy. Getting it back is not: five years, unless the IRS agrees otherwise.

What counts as foreign earned income

Three words, each doing work.

• Earned. Pay for services you personally performed: wages, salary, commissions, bonuses, professional fees, and the net income of a business where your own work is what produces the money. A retirement pension, even from a foreign employer, is not earned. Neither is Social Security, interest, dividends, rent, a capital gain, or money from a business where capital is the main ingredient.
• Foreign. The work was done in a foreign country. Where you were paid, where the employer is, and what currency it came in do not matter. A Lone Tree engineer paid by a Denver company for a year in Qatar has foreign earned income. The same engineer flown back for three weeks of meetings in Denver earned those three weeks in the United States, and that part cannot be excluded.
• Income. Includes more than the paycheck: housing an employer provides, cost-of-living and education allowances, a car, home leave. These are counted at value, and the form has lines for them. Pay from the U.S. government, including the military, is never foreign earned income for this purpose, however far away it is earned.

The three things you have to show

Before any income is excluded, the IRS wants three things established, and the order matters.

First, your tax home is in a foreign country. Your tax home is the general area of your main place of work. If you work in Dubai, your tax home is in Dubai, whatever your mailing address says. This is the same “tax home” concept that governs travel deductions.

Second, you do not have an abode in the United States. This is the one that catches people, and it is the one we spend the most time on. The Code says the exclusion is not available to anyone who has an “abode” in the United States during the period in question. Abode is not the same thing as owning a house. It means the place where you actually live, your home base, where your family and your life are. Keeping the house in Castle Rock while you work in Saudi Arabia, with a tenant in it or sitting empty, is fine. Living in the house in Castle Rock while rotating out to a rig for 28 days at a time, coming home between hitches, is not; the courts have said so repeatedly, and those cases were offshore workers exactly like that. The question we ask is: where would a stranger say you live? If the honest answer is Colorado, Form 2555 is not going to work, however many days you spent away.

Third, you pass one of the two tests.

• Bona fide residence. You have actually settled in a foreign country, for an uninterrupted period that includes an entire calendar year, with no present plan to leave on a set date. A lease or a purchased home, family with you, a local bank account, a residence visa, taxes paid locally. Trips home for the holidays do not break it. Telling the foreign country’s tax authority that you are not a resident there, to avoid their tax, ends it: the form asks that question directly. Once you have the full calendar year, the test covers the partial years on either end as well.
• Physical presence. Arithmetic, nothing more. 330 full days in a foreign country during any period of 12 consecutive months. A full day is a 24-hour day starting at midnight; the day you fly out and the day you fly in do not count, and neither does time over international waters. Any 12-month period works, not just the calendar year, so a contract that started in March can qualify with a period of March to March, with the exclusion prorated for the part of each calendar year that falls inside it. You get 35 days a year in the U.S. or in transit, and we count every one of them from your passport and your travel records.

Most of our clients use physical presence the first year and bona fide residence after that. The form asks for the full travel history either way.

The housing exclusion

On top of the earned income exclusion there is a second one for housing. Reasonable foreign housing costs — rent, utilities other than telephone, insurance, repairs, furniture rental, parking — above a base amount can be excluded if your employer pays them, or deducted if you are self-employed. For 2026 the base is $21,264 (16% of the earned income exclusion) and the general cap is $39,870 (30%), so the most a person in an ordinary city can exclude is about $18,600. The IRS publishes a table every year of expensive cities with higher caps; London, Hong Kong, Tokyo, Zurich and a hundred others are on it, and in some of them the cap is more than double the standard figure. The purchase price of a home, a mortgage, and anything lavish do not count.

The catch: the stacking rule

Here is the part nobody is ready for. Until 2006, excluded income simply vanished. You excluded $80,000, and whatever was left was taxed from the bottom of the brackets, as if the $80,000 had never existed. Congress changed that in the Tax Increase Prevention and Reconciliation Act of 2006. Since then the excluded income is taken out, but your remaining income is taxed at the rates it would have faced if the excluded income were still in the pile underneath it. The excluded pay is the foundation; everything else is stacked on top of it and taxed from there.

What that means in practice: a person who excludes all $132,900 of foreign wages, and who also has $60,000 of income that cannot be excluded, pays tax on that $60,000 starting in the 22% and 24% brackets, not the 10% and 12% brackets. The return runs this through a worksheet, the Foreign Earned Income Tax Worksheet, which figures the tax on everything, then subtracts the tax on the excluded amount alone. The difference is the tax. It is roughly double what the client expects.

The same stacking applies to capital gains and qualified dividends, which are figured on their own worksheet with the excluded income added back, and to the alternative minimum tax. There is no way around it that we know of other than choosing the foreign tax credit instead, which is the next section.

Exclusion or credit?

There is a second way to keep foreign pay from being taxed twice, and it is sometimes the better one. The foreign tax credit, on Form 1116, lets you subtract the income tax you paid to the foreign country from your U.S. tax on the same income, dollar for dollar, up to the U.S. tax on that income. You cannot take the credit on income you excluded; it is one or the other for each dollar, though you can exclude up to the limit and take the credit on the pay above it.

The rule of thumb: in a high-tax country, the credit is usually at least as good as the exclusion and often better, because the foreign tax wipes out the U.S. tax, no stacking rule applies, the unused credit carries forward ten years, and you keep the refundable child tax credit and the right to put money in an IRA. In a country with low or no income tax — the Gulf states, Singapore at lower incomes, much of the Caribbean — the exclusion is the only thing standing between you and full U.S. tax, and it is clearly the right choice. We run both before filing. The complication is the five-year rule: once you have been taking the exclusion and you switch to the credit on the same income, you have revoked the election, and you cannot go back to the exclusion for five years without a ruling from the IRS. A move from Dubai to Amsterdam can turn that into a real question, and it deserves a conversation before the return is filed rather than after.

Things the exclusion changes that people do not expect

• Self-employment tax is not excluded. If you are self-employed abroad, the exclusion takes your net profit out of income tax, but the full 15.3% of Social Security and Medicare tax is still due on it, unless the country you are in has a Social Security agreement with the U.S. and you are covered there instead. That is often the largest number on an expatriate contractor’s return.
• No IRA contribution from excluded pay. An IRA needs compensation that was included in income. If all of your earnings were excluded, you have no room to contribute, and a contribution made anyway is an excess subject to penalty every year it sits there.
• No earned income credit, no refundable child tax credit. Filing Form 2555 disqualifies the household from the earned income credit altogether, and the refundable part of the child tax credit is off the table as well. The nonrefundable credit survives.
• Deductions tied to the excluded income are lost. Expenses that relate to earning the excluded pay cannot be deducted; they are matched against income that is already not taxed.
• The foreign tax credit shrinks. Foreign tax paid on the excluded portion of your pay cannot be credited. Only the tax on what was not excluded counts.
• State tax is separate. The federal exclusion does not automatically carry to the state. See Colorado, below.

The forms that come with it

Living abroad brings reporting that has nothing to do with the exclusion and that carries the largest penalties in the Code if it is missed.

• FBAR. If the combined balance of all your foreign bank, brokerage and pension accounts went over $10,000 at any point in the year, even for a day, FinCEN Form 114 is due by the return deadline, filed online, separately from the 1040. The penalty for a non-willful miss starts in the five figures per year.
• Form 8938. The same accounts, plus foreign stock, partnership interests and some insurance, reported with the return if the total was over $200,000 at year end or $300,000 at any time for a single person living abroad (double for a joint return). Lower thresholds apply if you still live in the U.S.
• Foreign retirement plans and mutual funds. Both can trigger their own forms (3520 and 8621 among them) and, in the case of foreign mutual funds, a tax treatment harsh enough that we generally tell clients to sell them before leaving.

Americans abroad get an automatic two-month extension, to June 15, and can extend to October 15 like anyone else. Interest on a balance still runs from April 15.