Everything starts with the tax home, and it is where people fail first. Section 911(d)(3) borrows the concept from the travel expense rules: your tax home is your regular place of business, and you are not treated as having a tax home in a foreign country for any period during which your abode is in the United States. Abode is about domestic and family ties rather than about a house, so a worker who spends most of the year on a project overseas while the family home, the bank accounts and the driver's license all remain in one American town can fail this test even when the day count is comfortable. A narrow exception applies to those serving in a designated combat zone in support of the Armed Forces.
Then one of two qualifying tests, and they are not equally available.
The bona fide residence test at section 911(d)(1)(A) requires that the individual be a citizen of the United States who has been a bona fide resident of a foreign country for an uninterrupted period that includes an entire taxable year. Note the two constraints inside that sentence. The statute opens it to citizens, so a resident alien generally has to use the physical presence test instead, and the period must include a full tax year, which for a calendar-year filer means January through December. Once established, it tolerates ordinary travel, including trips back to the United States, because it is about the character of the residence rather than about days.
The physical presence test at section 911(d)(1)(B) is open to a citizen or a resident of the United States and asks only for presence in a foreign country or countries during at least 330 full days in any period of 12 consecutive months. Two details do most of the damage. The days must be full days, meaning complete 24-hour periods, and time spent over international waters counts as being in neither country, so a long flight can cost a day at each end. And the 12-month window is any consecutive twelve months, not a calendar year, so it can be selected to capture the best run.
The exclusion reaches earned income only, and the statute says what that excludes. Foreign earned income is pay for services performed abroad during the qualifying period. Section 911(b)(1)(B) removes from it amounts received as a pension or annuity and amounts paid by the United States or an agency of it to its employees, which is why a federal civilian employee posted overseas cannot use it on their salary. Dividends, interest, capital gains, rental income and Social Security benefits are not earned income at all and were never within reach. Where personal services and capital are both material income-producing factors, as in an owner-operated business, a reasonable allowance for the services counts as earned income up to 30 percent of the owner's share of net profits.
The housing companion, in percentages rather than dollars. Section 911(a) allows a second election covering a housing cost amount, which is reasonable foreign housing expenses in excess of a base figure. The base is set at 16 percent of the exclusion amount, computed on a daily basis and multiplied by qualifying days, and the amount of expenses that may be counted is capped at 30 percent of the exclusion amount on the same daily basis. The Secretary is authorized to raise that 30 percent cap for locations where housing is expensive relative to the United States, and does so through an annual notice listing them, so the effective ceiling in a high-cost city is larger than the default. Interest and taxes deductible under other provisions are excluded from housing expenses, as are expenses that are lavish or extravagant. An employee takes it as an exclusion; a self-employed individual takes it as a deduction.
Four consequences that catch people after the election is made.
The stacking rule in section 911(f) means the exclusion does not put you back at the bottom of the rate table. Tax on the income that remains is computed as though the excluded amount had been included, so the first dollar of unexcluded income is taxed at the rate that would have applied above the exclusion rather than at the lowest rate. The exclusion removes income; it does not reset the brackets.
Self-employment tax is unaffected. Section 1402(a)(11) provides that the section 911(a)(1) exclusion does not apply in computing net earnings from self-employment, so a self-employed American abroad still owes self-employment tax on income excluded for income tax purposes, unless a totalization agreement between the United States and the host country assigns social security coverage to that country instead.
The election is sticky in both directions. Once made, it applies to that year and every year after until revoked. Once revoked, section 911(e)(2) bars a further election for any year before the sixth taxable year after the year of revocation, except with the consent of the Internal Revenue Service. A taxpayer who switches to the foreign tax credit because it produces a better result in one year has therefore made a five-year decision, not a one-year one.
Finally, the exclusion is a federal provision. States set their own rules, and a taxpayer who has not severed residency with a state may find the state taxing income the federal return excludes. Excluding income also does not remove any reporting obligation: the return must still be filed, and separate reports for foreign financial accounts and foreign assets are unaffected by it.
