Foreign housing exclusion: Meaning, Criticisms & Real-World Uses

Foreign Housing Exclusion

The Foreign Housing Exclusion is a provision under U.S. tax law that allows qualifying U.S. citizens and resident aliens living and working abroad to exclude a portion of their housing expenses from their gross income for U.S. federal income tax purposes. This exclusion is a key component of international taxation for individuals, designed to alleviate the financial burden of living costs in a foreign country. It works in conjunction with the Foreign Earned Income Exclusion (FEIE) and is aimed at preventing double taxation on income earned overseas. The foreign housing exclusion specifically addresses the often higher cost of living, particularly housing, in many foreign locations.

History and Origin

The framework for U.S. taxation of citizens living abroad, including provisions like the Foreign Housing Exclusion, has roots in the broader Foreign Earned Income Exclusion. The FEIE was first introduced as part of the Revenue Act of 1926. Initially, this aimed to incentivize U.S. citizens to work overseas by providing substantial tax relief on income earned outside the United States. Over the decades, the provisions evolved. Congress made changes to the maximum exclusion amounts and added specific allowances for housing costs. The intent was to ensure that U.S. citizens working in foreign countries would be competitive with citizens of other nations who typically are not taxed by their home countries on foreign-earned income¹⁹, ²⁰. For example, significant adjustments were made through the Tax Increase Prevention and Reconciliation Act of 2005, which indexed the FEIE to inflation and refined how the Foreign Housing Exclusion was calculated and limited, tying it more directly to the FEIE amount¹⁸.

Key Takeaways

The Foreign Housing Exclusion allows eligible U.S. citizens and resident aliens living abroad to reduce their taxable income by excluding certain housing expenses.
Eligibility typically requires meeting either the bona fide residence test or the physical presence test and having a tax home in a foreign country.
The amount of the exclusion is tied to the Foreign Earned Income Exclusion (FEIE) and has a base housing amount that must be exceeded before any expenses can be excluded.
The exclusion is claimed by filing IRS Form 2555, "Foreign Earned Income."
Higher exclusion limits may apply for individuals living in designated high-cost localities.

Formula and Calculation

The Foreign Housing Exclusion calculation involves determining qualified housing expenses, subtracting a base housing amount, and applying an overall limit. This exclusion is a portion of a taxpayer's foreign housing expenses that exceeds a statutory base housing amount, up to a certain maximum.

The formula for the excludable housing amount is:

\text{Housing Exclusion} = \text{Qualified Housing Expenses} - \text{Base Housing Amount}

Where:

Qualified Housing Expenses: Reasonable expenses paid or incurred for housing in a foreign country for the tax year. This includes rent, utilities (excluding telephone charges), property insurance, fees for securing a lease, furniture rental, and repairs. Extravagant or lavish expenses are not included¹⁷.
Base Housing Amount: A statutory amount that the IRS considers a basic level of housing expense for any taxpayer, regardless of location. For the 2025 tax year, the base housing amount is $20,800, which is 16% of the 2025 Foreign Earned Income Exclusion of $130,000¹⁵, ¹⁶.
Maximum Housing Exclusion Limit: Generally, the qualified housing expenses eligible for the exclusion are limited to 30% of the maximum FEIE. For 2025, this standard cap is $39,000 ($130,000 * 30%)¹³, ¹⁴. However, for certain high-cost localities, the IRS publishes higher maximum exclusion amounts¹².

The exclusion amount is capped at the lesser of the actual qualified housing expenses (minus the base housing amount) or the maximum housing exclusion limit for the specific location.

Interpreting the Foreign Housing Exclusion

The Foreign Housing Exclusion directly reduces a qualifying individual's gross income for U.S. tax purposes. This means that the excluded amount is not subject to federal income tax. For an individual, a higher excludable amount translates to a lower tax liability. The base housing amount signifies a threshold: only housing expenses above this baseline can be considered for the exclusion. If an individual's housing costs are below the base amount, they generally cannot claim the exclusion. The varying limits for high-cost localities acknowledge the significant differences in living expenses across different global cities and regions, allowing taxpayers in expensive areas to exclude more to reflect their actual costs¹¹.

Hypothetical Example

Consider an American citizen, Sarah, working in London for the entire 2025 tax year. She meets the physical presence test for the Foreign Earned Income Exclusion. Her total qualified housing expenses for the year amount to $50,000.

Determine the Base Housing Amount: For 2025, the base housing amount is $20,800¹⁰.
Calculate the Excess Housing Expenses: Sarah's qualified housing expenses ($50,000) minus the base housing amount ($20,800) equals $29,200. $\$50,000 - \$20,800 = \$29,200$
Check Against the Maximum Exclusion Limit: While the standard maximum for 2025 is $39,000, London is considered a high-cost locality. Assume the IRS-published limit for London for 2025 is $70,000 (a hypothetical figure for illustration, actual amounts are published by the IRS)⁹.
Determine the Excludable Amount: Since Sarah's excess housing expenses ($29,200) are less than the hypothetical London limit ($70,000), she can exclude the full $29,200.

This $29,200 would be subtracted from Sarah's gross income when calculating her U.S. federal income tax, thereby reducing her overall tax liability.

Practical Applications

The Foreign Housing Exclusion is primarily applied by U.S. citizens and resident aliens who live and work abroad and meet specific residency tests. It is a crucial tool in personal financial planning for expat taxes, helping to reduce the U.S. tax burden for those whose housing costs in a foreign country are substantial. Taxpayers claim this exclusion on IRS Form 2555, alongside the Foreign Earned Income Exclusion. This exclusion can be particularly beneficial for individuals working in major international cities with high rental markets, as the Internal Revenue Service (IRS) provides higher limits for designated high-cost localities. Detailed information can be found in IRS Publication 54, "Tax Guide for U.S. Citizens and Resident Aliens Abroad"⁷, ⁸.

Limitations and Criticisms

Despite its benefits, the Foreign Housing Exclusion has limitations. It is not available if housing expenses do not exceed the base housing amount, meaning individuals in lower cost-of-living areas or those with employer-provided housing that isn't included in their taxable income may not benefit. The exclusion also does not reduce self-employment tax, only regular income tax⁶.

More broadly, the Foreign Housing Exclusion, like the Foreign Earned Income Exclusion, operates within the context of the U.S.'s unique citizenship-based taxation system. Unlike nearly all other developed nations that tax based on residency, the U.S. taxes its citizens on their worldwide income regardless of where they live⁴, ⁵. This system has faced significant criticism. Organizations like American Citizens Abroad argue that it creates disproportionate financial burdens and complexities for overseas Americans, leading to issues beyond just double taxation, such as difficulty accessing foreign financial services³. While the foreign housing exclusion and other provisions aim to mitigate these effects, critics contend that they do not fully address the fundamental challenges posed by citizenship-based taxation.

Foreign Housing Exclusion vs. Foreign Tax Credit

The Foreign Housing Exclusion and the Foreign Tax Credit are both mechanisms U.S. citizens and resident aliens can use to reduce their U.S. tax liability while living abroad, but they serve different purposes and operate distinctly.

The Foreign Housing Exclusion directly excludes a portion of qualified housing expenses from a taxpayer's gross income, thereby lowering their adjusted gross income and subsequent taxable income. It is specifically for housing costs that exceed a base amount and are related to foreign earned income.

Conversely, the Foreign Tax Credit allows taxpayers to claim a dollar-for-dollar credit against their U.S. tax liability for income taxes paid to a foreign government. Its purpose is to prevent double taxation on the same income by offsetting U.S. taxes with foreign taxes already paid. The Foreign Tax Credit applies to income taxes, not specific expenses like housing. Taxpayers typically elect to use either the Foreign Earned Income Exclusion (which includes the Foreign Housing Exclusion) or the Foreign Tax Credit, as using both on the same income is generally not allowed. However, a taxpayer might use the FEIE for their salary and the Foreign Tax Credit for other types of income or if their foreign tax burden is higher than their U.S. tax burden after the FEIE.

FAQs

Who is eligible for the Foreign Housing Exclusion?

To be eligible, you must be a U.S. citizen or resident alien who meets one of the two residency tests—either the bona fide residence test or the physical presence test—and your tax home must be in a foreign country. You must also have foreign earned income.

What types of expenses qualify for the Foreign Housing Exclusion?

Qualified expenses include reasonable amounts paid for rent, utilities (excluding telephone charges), property insurance, fees for securing a lease, furniture rental, and necessary repairs. These expenses must be incurred for your housing in a foreign country.

#²## How does the base housing amount affect the exclusion?
The base housing amount is a threshold that your qualified housing expenses must exceed before any amount can be excluded. This amount represents what the IRS considers a basic housing cost. Only the expenses above this base amount are eligible for the exclusion.

#¹## Can I claim both the Foreign Housing Exclusion and the Foreign Tax Credit?
Generally, you cannot claim both on the same income. If you elect the Foreign Earned Income Exclusion (which includes the Foreign Housing Exclusion), the income excluded is not subject to U.S. tax, and therefore no foreign tax credit can be claimed on that excluded income. However, you might use the Foreign Housing Exclusion for certain foreign earned income and then use the Foreign Tax Credit for other foreign-sourced income that was not excluded and was subject to foreign taxes.

Where do I report the Foreign Housing Exclusion on my tax return?

You report the Foreign Housing Exclusion on IRS Form 2555, "Foreign Earned Income." This form is then attached to your main U.S. individual income tax return, Form 1040.