What is considered foreign earned income?

By Jason Watson (Google+)

To claim the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, you must have foreign earned income.

Foreign earned income is generally income you receive for services you perform during a period in which your tax home is in a foreign country and you either meet the bona fide residence test or the physical presence test.

Earned income includes salaries and wages, commissions, bonuses, professional fees and tips, and pass-through income from an S Corporation with material participation.

Note: International waters and international airspace DO NOT count as a foreign country. So being outside the United States is not the same as being in a foreign country. Earned income while performing services in international waters or international airspace will not be excluded using the foreign earned income exclusion. See Tax Court Summary 2012-12.

Unearned income includes dividends, interest, capital gains, gambling winnings (scrub the Atlantis Hotel trip), alimony, social security benefits, pensions and annuities.

Variable income can either be earned or unearned, and includes business profits, royalties, rents, scholarships and fellowships. For example, royalties such as gas and oil rights will be unearned income (and therefore not excludable under the foreign earned income exclusion). But royalties associated with writing a book would be considered earned income.

The timing of when your earned income is received can also affect which tax year you claim the income. Generally in the United States you report income in the tax period in which you receive the money; this is not always the case when dealing with foreign income.  Several foreign countries have fiscal year ends differing from the normal calendar year (Australia, Great Britain, India, and Canada, to name a few).  In those circumstances, a special allocation of the foreign income and foreign taxes paid is required, for calculations on your US tax return.

There are also several rules and exceptions associated with the reimbursement of moving expenses (see How do moving expenses affect my exclusion?).

Lastly, non-cash income such as the value of property (car) or facilities (lodging) is considered earned income at fair market value. And, allowances or reimbursements such as cost-of-living allowances, overseas differential, family allowance, education allowance or reimbursements, etc. will typically be considered earned foreign income.