Foreign Earned Income Exclusion vs Credit: Americans in Portugal

The IRS gives Americans abroad two tools against double taxation: the foreign earned income exclusion, which takes earned income out of U.S. taxable income (Form 2555), and the foreign tax credit, which subtracts foreign income tax from your U.S. tax (Form 1116). You cannot use both on the same income, and which one fits depends on what kind of income you have and how much; the IRS pages we read do not rank them.

Our guide to U.S. taxes for Americans in Portugal gives the overview and the headline amounts. This article goes deeper into the two tools themselves, strictly from IRS pages: who qualifies for the exclusion, what counts as earned income, how housing works, how you choose and revoke, and how the credit limit and carryover work. It is not tax advice and it does not compute your tax. It also says nothing about Portuguese tax rates, because we did not read the Portuguese tax authority’s pages for this article. It is written for U.S. citizens, and for Britons who are U.S. citizens or green card holders.

What we read, and what the date of this article refers to

We read the IRS pages named in the closing line on 18 October 2026. Each shows its own “last reviewed or updated” date, from 6 February 2026 for the tax home page to 5 August 2026 for the Publication 54 page. The Publication 54 page lists no recent developments, so the newest date that carries information is 9 July 2026, the foreign tax credit page, and that is the date of the information in this article. The exclusion amounts come from the IRS page on figuring the exclusion (reviewed 14 March 2026), and we quote them only for the tax years it states, 2025 and 2026. Publication 54 is the December 2025 revision, and the Form 2555 and Form 1116 instructions are the 2025 editions.

Which is better for an American in Portugal, the exclusion or the credit?

The IRS pages do not say. They describe what each tool does and what choosing one costs, and the choice depends on your income, which this article does not weigh. What they do say can be laid side by side:

IRS Publication 54 gives one pairing: a high wage earner can take the exclusion up to the limit for the year and then take a foreign tax credit for foreign taxes paid on the part of the wage that was not excluded. If you want to know which route leaves you with less U.S. tax, that is a calculation for a U.S. tax professional with your numbers.

Who qualifies for the foreign earned income exclusion?

The IRS says you need three things: foreign earned income, a tax home in a foreign country, and either the bona fide residence test or the physical presence test. Publication 54 sets out five requirements, the last being a valid election made by attaching Form 2555 to your return.

Tax home. The IRS defines it as the general area of your main place of business, employment or post of duty, regardless of where you maintain your family home. You do not have a foreign tax home for any period during which your abode is in the United States, and the IRS says the location of your abode is based on where you maintain your family, economic and personal ties. It does not follow that your abode is in the United States merely because you keep a dwelling there. On timing, the IRS says employment in a single location that you expect to last, and that does last, a year or less is temporary, and one you expect to last more than a year is indefinite. If you are temporarily absent from a U.S. tax home on business, you do not qualify.

Bona fide residence test. You must be a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year, which for a calendar-year filer means January 1 through December 31. The IRS says on this page:

“You do not automatically acquire bona fide resident status merely by living in a foreign country or countries for one year.”

Whether you qualify depends on the facts: the IRS lists your intention or purpose for being in the country, your activities there, and whether you paid taxes to that country, among other things, and it decides largely from what you report on Form 2555. Short trips back to the United States or elsewhere are allowed if you clearly intend to return to your foreign residence without unreasonable delay. Two points matter for people moving to Portugal. First, the test is open only to a U.S. citizen, or a U.S. resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect. Second, you are not a bona fide resident if you tell the foreign authorities that you are not a resident and they hold that you are not subject to their income tax laws as a resident.

The IRS illustrates the test with a Lisbon example. A U.S. employer’s representative arrives with family on November 1, 2024, on an indefinite assignment. After a month in the United States in April 2025, the person keeps living in Lisbon and on January 1, 2026 has completed an uninterrupted period covering the full tax year 2025, and may qualify. If the same person had transferred back on December 13, 2025, the stay would not include a full tax year and the bona fide test would not be met, though the physical presence test might be.

Once the test is met, you qualify from the date you began the residency until the date you abandon it, so you can qualify for parts of the years on either side of the full year.

Physical presence test. You must be physically present in a foreign country or countries for 330 full days during any period of 12 consecutive months. The days need not be consecutive. A full day is 24 consecutive hours from midnight to midnight, and time on or over international waters when you leave the United States or return does not count. The IRS example: a ship from Norway to Portugal that leaves at 10 p.m. on July 6 and arrives at 6 a.m. on July 8 costs you July 6, 7 and 8 as full days. The 12-month period can start on any day, and you may choose the period that gives you the greatest exclusion. The test depends only on days, not on the kind of residence or your intentions, and the IRS says you fail it for any reason, “including illness, family problems, a vacation, or your employer’s orders”, if you fall short of 330 days.

Both tests are open to a U.S. citizen, but only the physical presence test is open to every U.S. resident alien. The IRS pages also describe a waiver of the minimum time for people who must leave a country because of war, civil unrest or similar adverse conditions; we did not read the page listing the countries.

What counts as foreign earned income?

Pay for personal services you perform in a foreign country: wages, salaries, professional fees or other amounts paid for personal services. The IRS sorts income types in a table:

The exclusion also reaches self-employment income, and the IRS says the excluded amount reduces regular income tax but not self-employment tax. Pensions and social security cannot be excluded. That matters to a retiree who moves on the retirement and passive income visa: the exclusion is for pay for work, not for retirement income.

Where the work is done decides the source, not where you are paid. The IRS says income you receive for work done in France is foreign-source income even if your employer is in New York and the money goes to a U.S. bank account. That is the rule behind remote work: for someone on the remote work visa paid by a U.S. employer, pay for days worked in Portugal is foreign source on this reading. If you work partly in the United States, the IRS says to use the method that most correctly shows the source, in most cases a time basis, multiplying your total pay by days worked abroad over total days worked.

Other limits the IRS names: pay as a U.S. government employee is not foreign earned income, and neither are payments received after the end of the tax year following the year in which you performed the services. The IRS also says you earn income in the year you do the work even if you are paid later, which affects the cap for the earlier year. For the Portuguese side of employment and freelancing, see working in Portugal as an American or a Briton.

How much can you exclude, and how does housing work?

For tax year 2025 the IRS gives a maximum of 130,000 dollars per qualifying person, or the foreign income earned if less, and for 2026 it gives 132,900 dollars per person. If you are married and both of you work abroad and each meets a test, each can choose the exclusion; together the IRS says you can exclude as much as 260,000 dollars for 2025. If you qualify for only part of a year, you multiply the maximum by your qualifying days and divide by 365 (366 in a leap year). Publication 54 notes that it dropped the annual inflation figures from the publication, so the amounts come from the IRS web pages, and you should check the page for the year you file.

The housing amount is separate:

• Who gets what. The housing exclusion applies only to amounts considered paid with employer-provided amounts, such as salary or reimbursed housing. The housing deduction applies only to amounts paid with self-employment earnings.
• How it is figured. Your housing amount is your housing expenses minus a base housing amount, which is 16 percent of the maximum exclusion, pro-rated by days.
• The cap. The standard limit is generally 30 percent of the maximum exclusion, which the IRS puts at 39,000 dollars for 2025 and 39,870 dollars for 2026, but it varies with the location of your tax home and your qualifying days. The limits for high-cost places are in the Form 2555 instructions, which refer to an annual IRS notice; we did not read that notice, so we do not say what limit applies to Portugal.
• What does not count. The IRS lists lavish or extravagant expenses, the cost of buying property, purchased furniture or accessories, and improvements.
• Order. If you claim the housing exclusion you figure it first, because the earned income exclusion is limited to your foreign earned income minus the housing exclusion.
• Self-employment tax. Housing amounts do not reduce it either.

What does the exclusion cost you?

The IRS pages name several consequences, so they belong in the decision:

• You still file. The exclusion applies only if you file a return reporting the income. The IRS calls the idea that excluded income need not be reported a common misconception.
• Self-employment tax stays. Publication 54 shows a consultant with 95,000 dollars of foreign earned income and a 68,000 dollar net profit who pays self-employment tax on the 68,000 dollars even though the consultant qualifies for the exclusion.
• Credits you lose. If you exclude foreign earned income you cannot take the earned income credit or the additional child tax credit for that year.
• Higher rates on the rest. The tax on your remaining income is figured at the rates that would have applied had you not excluded anything, using the Foreign Earned Income Tax Worksheet in the Form 1040 instructions.
• No credit on the excluded income. Covered next.

How do you choose the exclusion, and how do you revoke it?

The exclusion is voluntary. You choose it on Form 2555, generally with a timely filed return including extensions, with a return amending a timely filed return, or with a late-filed return filed within 1 year of the original due date. The IRS says later choices are possible in some cases, with a special statement at the top of Form 1040, if you owe no tax after the exclusion or the IRS has not yet discovered the omission.

The first year can be awkward, because you may not yet have met a test by the filing deadline. The Form 2555 instructions give two options: apply for a special extension with Form 2350 to a date after you expect to qualify, or file on time without the exclusion and file an amended return (Form 1040-X) after you qualify. A Form 1040-X generally must be filed within 3 years after the original filing or 2 years after the tax was paid, whichever is later. For the regular deadlines see our guide to U.S. taxes for Americans in Portugal.

Once chosen, the choice stays in effect for that year and all later years unless you revoke it. To revoke, you attach a statement to the return for the first year you do not want it, say which choice you revoke, and revoke the earned income and housing choices separately. The IRS says you can revoke for any year, and that you do not need to revoke just because you have no foreign earned income for a year. If you revoke and within 5 tax years want the same exclusion again, you must apply for IRS approval by requesting a ruling; the IRS says it charges a fee and weighs facts such as a period of residence in the United States, a move to a country with different tax rates, a substantial change in the foreign country’s tax law and a change of employer. Publication 54 adds that deciding to take the foreign tax credit in a later year is itself treated as a revocation of your prior choice.

How does the foreign tax credit work, and what limits it?

If you paid or accrued foreign taxes and are subject to U.S. tax on the same income, the IRS says you may take either a credit or an itemized deduction. A deduction reduces your U.S. taxable income, a credit reduces your U.S. tax, and the IRS says that in most cases the credit is to your advantage. Generally only income, war profits and excess profits taxes qualify. If you take the credit for eligible foreign taxes, you generally cannot take any part of that year’s foreign taxes as a deduction. An individual claims the credit on Form 1116.

The limits that matter, from the Form 1116 instructions and the foreign tax credit pages:

The IRS Form 1116 instructions work through the limit line by line and refer to Publication 514 for the carryback and carryforward examples; we did not read Publication 514, so we do not reproduce its worked examples. Which Portuguese taxes meet the IRS definition of an income tax is not something we can say from the pages we read.

What happens when you use both the exclusion and the credit?

The IRS says that once you choose to exclude foreign earned income or housing, you cannot take a foreign tax credit or deduction for taxes on income you excluded or could have excluded. If you do, one or both choices may be considered revoked, from the year of the credit. The Form 2555 instructions spell out the split: if all your foreign earned income is excluded you cannot claim a credit for the foreign tax on it, and if only part is excluded you cannot claim it for the tax allocable to the excluded part. You can still take the credit on foreign earned income above what you excluded.

The Form 1116 instructions give the arithmetic for the reduction (line 12): multiply the foreign tax paid or accrued on foreign earned income by a fraction to find the tax allocable to the excluded income, and reduce the taxes available for credit by that amount. The numerator is the foreign earned income and housing amounts you excluded, less related expenses; the denominator is your total foreign earned income, less related expenses. Exclusion and credit do different jobs on different slices of income, which is the pairing Publication 54 describes for a high wage earner.

What does the U.S.-Portugal treaty add for the credit?

In the treaty text we read, the 1994 convention published by the IRS, Article 25 on relief from double taxation says that, in accordance with the provisions and subject to the limitations of U.S. law, the United States allows a resident or citizen a credit against U.S. tax on income for the income tax paid to Portugal. It also says that for a U.S. citizen who is a resident of Portugal, income the United States may tax solely by reason of citizenship is deemed to arise in Portugal to the extent necessary to avoid double taxation, provided the U.S. tax is not less than it would be if the person were not a citizen. So the credit is a U.S.-law credit, and the Form 1116 limits above still govern it. We did not read the technical explanation of the convention, so we do not say how the deeming rule interacts with the Form 1116 categories.

Related guides on this site: Portuguese tax residence; the U.S.-Portugal tax treaty; U.S. filing deadlines and extensions from abroad; FBAR and Form 8938 for Portuguese accounts.

More guides on this site: IRAs and 401(k)s while you live in Portugal.

What to take away

For work income earned in Portugal, the IRS offers an exclusion with tests, a cap, a housing amount and a long-lived election, and a credit with a limit and a carryover. They cannot be used on the same income, they can be combined on different parts of it, and a careless switch revokes the exclusion for years. Pensions and social security fall outside the exclusion. For your own numbers, use a U.S. tax professional who files expat returns.

We read the following IRS pages and documents on 18 October 2026: the foreign earned income exclusion overview, the pages on figuring and choosing it, the bona fide residence test, the physical presence test, tax home in a foreign country, what is foreign earned income, revoking your choice, the foreign housing exclusion or deduction, the foreign tax credit page and its compliance tips, the Publication 54 page and the December 2025 PDF, the 2025 instructions for Forms 2555 and 1116, and the U.S.-Portugal treaty text. We did not read Publication 514 or the annual housing notice.