November 2008

U.S. Citizens Living Abroad

Income and Housing Exclusions

 

The United States is one of just a few countries that taxes the worldwide income of its citizens, resident aliens, and domestic corporations, without regard to its source. Under a law changed in 2004, citizens who renounce their U.S. citizenship are subject to U.S. taxes for an additional ten years if their average income tax liability is $127,000 for tax year 2005 (or higher amount for later years) for the five prior years, or [have] a net worth of $2,000,000 on the date of expatriation. The United States has over 60 bilateral tax treaties and an additional 20 tax information exchange agreements (TIEA) with other countries to facilitate the exchange of tax reporting information. However, to avoid double taxation by two or more taxing authorities, the U.S. permits a credit for foreign taxes paid or accrued, as well as a foreign earned income exclusion and a foreign housing exclusion.

 U.S. Citizens and Residents Living Abroad

 Individuals living abroad may qualify for two exclusions:

 

  1. Foreign earned income exclusion: Qualifying individuals may exclude foreign earned income up to $85,700 in 2007 and $87,600 in 2008 attributable to his or her residence in a foreign country (Code Sec. 911(a)(1) and (b)(2)).
  2. Foreign housing exclusion: In addition to the foreign earned income exclusion, qualifying individuals may exclude housing expenses from gross income provided by his or her employer while living and working overseas (Code Sec. 911(a)(2)and (c)).

 

Foreign earned income is defined as: wages, salaries, professional fees, and other amounts received as compensation for personal services provided when the taxpayer’s home was in a foreign country and the taxpayer met either the bona fide residence or the physical presence test (Code Sec. 911(b)(1) and (d)(2). If the taxpayer engages in a trade or business in which labor and capital are material income-producing factors no more that 30% of the profits may treated as “earned income.”

The taxpayer must include in income (in addition to wages) the fair market value of compensation “provided in kind” such as (1) the fair rental value of lodging, (2) rent paid directly by the employer, (3) amounts paid by the employer for housing expenses, educational expenses for family members, and similar “perks.”

Housing expenses are defined as: amounts paid by an employer for rent, utilities (but not telephone charges), property insurance, residential parking, repairs, and the rental of furniture and other household items, for the employee and his family.

Limitations:

 

  1. Earned income exclusion is limited to the excess of foreign earned income over the housing expense exclusion. Computed on a daily basis, the maximum limit must be reduced ratably for each day the taxpayer does not qualify for the exclusion.
  2. Housing expense exclusion is limited to 30% of the amount of the maximum foreign earned income exclusion for the year ($85,700 and $87,600 for 2007 and 2008, respectively), computed on a daily basis and multiplied by the number of days of foreign residence (Code Sec. 911(c)(2) ). The maximum housing expense exclusion for 2007 and 2008, therefore, is $25,710 and $26,280, or $70.44 and $72 per day, respectively. The exclusion is further limited to the excess of the “reasonable foreign housing expenses” over the “base amount” equal to 16% of the maximum foreign earned income exclusion ($85,700 and $87,600 for 2007 and 2008, respectively), multiplied by the number of days of foreign residence or $ 13,712 and $14,016 ($37.57 and $38.40 per day), respectively.  The IRS may adjust the limitation for geographic areas that have higher housing costs.

Bona fide residence or physical presence:

To qualify for the foreign earned income exclusion a U.S. citizen or resident alien must

 

  1. meet the “tax home” test, and
  2. be a bona fide resident of a foreign country(s) for an uninterrupted period that includes a full tax year (January 1 through December 31) (Code Sec. 911(d)(1)(A) and (d)(5)),  or
  3. be present (business or personal) in a foreign country(s) for 330 days out of any consecutive 12-month period (Code Sec. 911(d)(1)(B) ). (The taxpayer may elect any 12-month period in order to meet the “physical presence” test.)

 

(Note: If a taxpayer’s only income is from work abroad for the U.S. government as an employee, he or she does not qualify for either exclusion.)

Tips: If the physical presence began in the current year, use the first arrival date and count forward 330 qualifying days. The 330th day is the last day of the qualifying period, while 365 days before is the first day of the qualifying period. If the physical presence ended in the current year, use the last departure date and count backward 330 qualifying days. The 330th day is the first day of the qualifying period, while 365 days later is the last day of the qualifying period. Do not count days spent in the U.S. or a “restricted” country when calculating the qualifying period.

Tax Home: According to IRS instructions for Form 2555: Foreign Earned Income

“Your tax home is your regular or principal place of business, employment, or post of duty, regardless of where you maintain your family residence. To meet this test your tax home must be in a foreign country(s) throughout your period of bona fide residence or physical presence [330 days], whichever applies.”

Bona fide resident: There is no specific rule that determines “bona fide” residence, but according to the IRS

“If you go to a foreign country for a definite, temporary purpose and return to the United States after you accomplish it, you are not a bona fide resident of the foreign country. If accomplishing the purpose requires an extended, indefinite stay, and you make your home in the foreign country, you may be a bona fide resident.”indicate if you are required to pay tax to the country where you claim bona fide residence.

As a practical matter, however, if the taxpayer submitted a statement to the authorities of the foreign country that he or she is not a resident of that country, and is not required to pay income tax to that country, he or she is not a bona fide resident of that country, and, as a result, can not claim either the foreign income or housing exclusion.

Physical Presence Test: The 330 full days during any 12-month period can be interrupted for travel over international waters or the taxpayer is otherwise not in a foreign country.

Example 1:

Jack Jones is a U.S. citizen arriving in Sydney, Australia on January 2, 2006 to begin work. Jack continues to work in Australia until October 31, 2007, earning $50,000. Jack has not met the bona fide residence test which requires

an uninterrupted period that includes a full tax year (January 1 through December 31). But Jack has met the physical presence test for 330 days out of any consecutive 12-month period. Jack has spent a total of 668 days in Australia (from 01/02/06 to 10/31/07); however, the physical presence test is based on the 12-month period from 12/06/2006 through 12/05/2007 – arrived at by counting back 330 days from his October 31, 2007 departure date. The 330th day is the start of Jack’s 365-day qualifying period, ending on 12/05/2007. Jack spent a total of 339 days in Australia during the period beginning on 12/05/2006 and ending 12/05/2007.

Assuming no foreign housing exclusion, Jack can exclude $50,000 ($85,700 X (339/365) – the lesser of the foreign earned income ($50,000 or the maximum foreign earned income exclusion for the year multiplied by the ratio of bona fide days abroad to 365 days ($79,615)

Example 2:

Assume the same facts in Example 1, except that Jack’s employer provided him with non-cash income consisting of housing valued at $20,000, meals worth $10,000, and the use of a car at $5,000.

These non-cash items are included in foreign income earned in the current period. As a result, Jack’s 2007 foreign income is $85,000 (Wages, $50,000; Lodging, $20,000; Meals, $10,000; and a Car, $5,000). Jack can exclude $79,615 – the maximum foreign earned income exclusion for the year multiplied by the ratio of bona fide days abroad to 365 days ($85,700 X (339/365).

Example 3:

Assume the same facts in Example 2, except that Jack has qualified housing expenses for the tax year of $25,000 consisting of rent, utilities, personal property insurance, rental of furniture and accessories, residential parking, and household repairs. Jack included the value of lodging paid by his employer ($20,000) in income.

The daily limit on housing expenses for Sydney, Australia is $70.44 per day. The number of qualifying days in Jack’s qualifying period is 339. Therefore, only $23,879 of Jack’s housing expenses are considered “reasonable.”

Jack may exclude the excess of his “reasonable” housing expenses over a base amount. The base amount is equal to 16% of the maximum foreign earned income exclusion: $13,712 ($85,700 x .16) or $37.57 per day. Jack’s base amount is $12,736 ($37.57 x 339). Therefore, Jack’s housing exclusion is $11,143 ($23,879 minus $12,736).

The housing allowance exclusion can change the earned income allowance. The housing allowance exclusion is first deducted from foreign earned income before calculating the earned income allowance. Jack’s foreign earned income was $85,000 in example 2. After the housing exclusion his foreign earned income is $73,857 ($85,000 minus $11,143), which becomes his new foreign income exclusion.

For a more complete discussion see IRS Publication 54: Tax Guide for U.S. Citizens and Residents Abroad.

Foreign Taxes:

A credit or deduction cannot be taken for foreign taxes paid on income that is excluded from U.S. gross income.

VB&T Certified Public Accountants, PLLC

212-448-0010

  November 1, 2008

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