If a U.S. person's tax home is in a foreign country and they meet either the bona fide residence test or the physical presence test, they can choose to exclude from gross income a limited amount of their foreign earned income. The income must be for services performed in a foreign country during a period of foreign residence or presence, whichever applies.

Prior to the Tax Reconciliation Act of 2005 (see below), the amount of foreign wages and salary that could be excluded was limited to the lesser of a person's actual foreign wages or $80,000. For an established foreign resident, the exclusion can be pro-rated based on the amount of time actually spent abroad.

A U.S. person who claims the Exclusion cannot claim any credits or deductions that are related to the excluded income, for instance a foreign tax credit or deduction for any foreign income tax paid on the excluded income. The earned income credit is also unavailable. Furthermore, for IRA purposes, the excluded income is not considered compensation and, for figuring deductible contributions in an employer retirement plan, is included in modified adjusted gross income.

The IRS confirmed that:

"Effective for tax years beginning after 2005, the amount of foreign earned income (and foreign housing costs) excluded from an individual's gross income will be used for purposes of determining the rate of income and alternative minimum tax (AMT) that applies to his or her nonexcluded income."

"The Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) adds a new section 911(f) to the Internal Revenue Code. An individual's tax will be the excess of the tax that would be imposed if his or her taxable income were increased by the amount(s) excluded, and the tax that would be imposed if his or her taxable income were equal to the excluded amount(s)."

"For this purpose, the excluded amount(s) will be reduced by the aggregate amount of any deductions or other exclusions otherwise disallowed. In many cases this will have the effect of increasing an individual’s U.S. federal income tax to an amount greater than it would have been under prior law."

For tax year 2006 the maximum amount of the Foreign Earned Income Exclusion under section 911 of the Internal Revenue Code was increased to $82,400.
 

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