This article explores how you may be able to take advantage of being a digital nomad to significantly reduce or even eliminate your U.S. personal income taxes.
If you’re not yet a digital nomad, and you are looking for help finding a job, becoming a freelancer, or launching a business that allows you to work remotely so that you can become a digital nomad, then my next post is going to be for you.
Important Disclaimer: I am NOT a lawyer or a tax accountant. This article is for informational purposes only. The information here is what I have gathered from IRS forms and instructions, and from reading other websites and articles on the same topic. Do not treat this as professional tax advice or legal counsel. Use this article as a starting point for doing your own research, and consider hiring a tax lawyer or accountant to help you. Keep in mind also that tax laws change frequently.
Background: That pretty blue passport comes with a price
Unlike almost every other country in the world, the United States requires its citizens to file and pay taxes, even if they don’t live in the United States. According to the Internal Revenue Service (IRS):
If you are a U.S. citizen or a U.S. resident alien living in a foreign country, you are subject to the same U.S. income tax laws that apply to citizens and resident aliens living in the United States.
Wait, so you are saying that even if I move to Mexico tomorrow and live there for the rest of my life, I still need to file a U.S. tax return every year?
Yes, as long as you earn at least $12,000 per year and you have not renounced your U.S. citizenship.
And I still need to pay taxes to the U.S. government?
Maybe, like everything tax-related, it’s complicated.
Enter the Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion is a provision of the United States tax code that allows you to exclude income that you earn outside of the United States from your taxable income.
In other words, if you live and make money in another country, you probably still need to file a tax return with the IRS, but you might* not actually have to pay any taxes.
*Your actual tax bill depends on a huge number of factors, including how much money you make, whether you are single or married, and what type(s) of income you have (employee, self-employed, collecting rent, selling assets, etc).
For tax year 2019, the IRS allows taxpayers to exclude up to $105,900 of foreign earned income (for single filers or married couples filing separately; double that for married couples filing together, assuming that they both qualify for the exclusion).
If you earn less than $105,900, and you earn all of that income while you are outside of the country, then you could avoid paying any federal income tax.
If you earn more than that amount, then you can still exclude up to $105,900 of foreign earned income. If you are in the top tax bracket of 37%, that would reduce your taxes by $39,183.
Compare that to the $2,000 tax credit you receive for each child… Bye-bye baby. Hello Bali!
But don’t go spending all that money just yet…
How Do You Qualify for the Foreign Earned Income Exclusion?
The IRS has several “tests” that they use to determine whether you can claim the Foreign Earned Income Exclusion. In order to qualify for the foreign earned income exclusion, the IRS requires you to pass the “Tax Home Test” and either the “Bona Fide Residence Test” or “the Physical Presence Test”.
There are some other restrictions as well, for example, you need to earn the income outside of the United States (obviously), and income from working abroad as an employee of the U.S. Government does not qualify for either the exclusion.
According to the IRS, in order to pass the Bona Fide Residence test you must be:
A U.S. citizen who is a bona fide resident of a foreign country, or countries, for an uninterrupted period that includes an entire tax year.
A “bona fide resident” means that you legitimately live in the other country, and you can demonstrate your ties to that country (for example: you spend most of your time there, your kids are in school there, you have a driver’s license there, you pay taxes to that government, etc).
It seems clear that if you move out of the United States completely, settle in another country and get a job there, then you would pass the Bona Fide Residence Test and could qualify for the Foreign Earned Income Exclusion.
Even if you don’t move to another country permanently, but you are sent by your employer to work there for an extended, and indefinite period of time, then you could probably still qualify for the Foreign Earned Income Exclusion based on the Bona Fide Residence Test.
That all sounds great for expats, but what about digital nomads who aren’t moving to one specific country?
Most digital nomads probably won’t pass the Bona Fide Residence Test, because we do not live in one particular country long enough. Plus, we generally travel on tourist visas, and don’t establish formal residency in the countries that we visit.
The alternative to qualifying via the Bona Fide Residence Test is the Physical Presence Test. This is the test that could apply to you as a digital nomad. According to the IRS:
To meet this test, you must be a U.S. citizen or resident alien who is physically present in a foreign country, or countries, for at least 330 full days during any period of 12 months in a row. A full day means the 24-hour period that starts at midnight.
To figure 330 full days, add all separate periods you were present in a foreign country during the 12-month period shown… the 330 full days can be interrupted by periods when you are traveling over international waters or are otherwise not in a foreign country.
In other words, you can pass the Physical Presence Test if you are physically present in countries other than the United States for at least 330 days out of a 365 day period. Note that some travel days may not count towards the 330 days. Any days you spend entirely in or over international waters, or any days you leave from or arrive in the United States would not count.
One other thing that’s very important to note here, the 330 days are the minimum. If you are only present in a foreign country for 329 days, you don’t qualify (except in certain extreme circumstances, like if you had to move due to a war).
So, if you are a digital nomad who spends 330 days or more outside of the United States, you may pass the Physical Presence test. But in order to claim the Foreign Earned Income Exclusion, you must also pass the Tax Home Test. This is where it gets a little more complicated.
To pass the Tax Home test, your tax home must be in a foreign country, or countries, during the time that you earn the income you want to exclude under the Foreign Earned Income Exclusion.
According to the IRS:
Your tax home is your regular or principal place of business, employment, or post of duty, regardless of where you maintain your family residence. If you don’t have a regular or principal place of business because of the nature of your trade or business, your tax home is your regular place of abode (the place where you regularly live).
If your abode is in the United States, you will not meet the tax home test and cannot claim the foreign earned income exclusion. The location of your abode is based on where you maintain your family, economic, and personal ties.
Based on all of that, it would seem like digital nomads who are originally from the United States, but now move around from country to country would not be able to claim a foreign tax home, would not pass the Tax Home Test, and would not be able to claim the Foreign Earned Income Exclusion.
However, the IRS also says:
If you do not have a regular or main place of business because of the nature of your work, your tax home may be the place where you regularly live. If you have neither a regular or main place of business nor a place where you regularly live, you are considered an itinerant and your tax home is wherever you work.
Taking that “itinerant” clause into account, it seems like digital nomads who leave the United States for an indefinite period, spend at least 330 days outside of the United States within twelve months, and travel from place to place while working could pass both the Tax Home Test and the Physical Presence Test and qualify for the Foreign Earned Income Exclusion.
But don’t I need some underlying business reason to travel to these other countries?
No. The IRS does not specify that the nature of your travel must be for business purposes:
You can count days you spent in a foreign country for any reason. You do not have to be in a foreign country only for employment purposes. You can count days you spent in a foreign country while on vacation (or for any other purpose) so long as on those days your tax home is still in a foreign country.
Are you sure this is all legal?
The Foreign Earned Income Exclusion is completely legal, in the sense that it is part of the United States’ tax law, but your individual circumstances determine whether or not you qualify to claim the exclusion.
The IRS created a YouTube video introduction to the Foreign Earned Income Exclusion and an online wizard to help you determine if you qualify.
What’s the catch?
There is no “catch” but there are some considerations that you should be aware of if you decide to claim the Foreign Earned Income Exclusion:
Maintaining your eligibility under the Physical Presence Test severely limits the amount of time you can spend in the United States in a given twelve month period.
Just because you qualify for the Foreign Earned Income Exclusion does not necessarily mean that you don’t have to pay any taxes at all. If you are self-employed, or an employee of a United States employer, you may still need to pay social security and medicare taxes.
You may also need to pay income tax in the country or countries where you are living.
Keep in mind that even if you qualify to exclude your foreign earned income, any money that you earn while in the United States (since the Physical Presence Test does allow you to spend some time in the United States, and the twelve month period that you use to qualify may not line up with the calendar year start and end) is still taxable. Also, not all income qualifies for the exclusion:
Foreign earned income doesn’t include amounts that are actually a distribution of corporate earnings or profits rather than a reasonable allowance as compensation for your personal services. It also doesn’t include the following types of income.
- Pension and annuity income (including social security benefits and railroad retirement benefits treated as social security).
- Interest, ordinary dividends, capital gains, alimony, etc.
You can find more information about the Foreign Earned Income Exclusion on the IRS website and in IRS Publication 54, “Tax Guide for U.S. Citizens and Resident Aliens Abroad”.
How can I claim the Foreign Earned Income Exclusion?
You can claim the Foreign Earned Income Exclusion on your personal income tax return by filing IRS Form 2555 Foreign Earned Income (here are the instructions for that form).
Alternatively, most of the tax preparation software packages and services, such as TurboTax and H&R Block also support the Foreign Earned Income Exclusion.
If you’re not yet a digital nomad, and you are looking for help finding a job, becoming a freelancer, or launching a business that allows you to work remotely so that you can become a digital nomad then my Office Escape Plan course is for you.