Q: Tax Playa, I worked overseas for a couple of years and paid income tax in that country. Do I have to pay tax on that money again here in the U.S.?
Moyra, Alexandria VA
A: Total worldwide income is taxable for all U.S. citizens and resident aliens. It matters not whether or if that worldwide income was taxed by another nation. As a result, there is a definite chance of double-taxation. To alleviate the most common instance of double taxation (on wages and self-employment income of Americans working overseas), the tax code allows for an exclusion for some foreign earned income...
For more information on the foreign earned income exclusion, please consult IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
In order to qualify for the exclusion, you must pass three tests:
- Your tax home (place where you work) must be in a foreign country
- You must have foreign earned income (does not include lodging, meals, fringes)
- You must pass either the "bona fide" residence or "physical presence" test in a foreign country
The "bona fide" residence test is passed if you have a home in a foreign country for at least one uninterrupted tax year. Generally, the tax law anticipates that you have moved to this country with the intention of staying there for a long while. Most people claim the physical presence test instead.
The "physical presence" test is passed if, during any 12-month period, you were present in a foreign country for any 330 days. They need not be consecutive, nor does the 12 month period have to be concomitant with a calendar or other tax year. For instance, if you were present from July 1 to June 30 the next year, and you only left the country for a couple of weeks at Christmas, you pass the test.
Claiming the Exclusion
There is a limit on the amount of foreign earned income that can be excluded. The limit in 2008 is $87,600 (inflation-adjusted thereafter). If the bona fide residence or physical presence tests are only passed for part of a year, it must be pro-rated. For example, our taxpayer above who qualified beginning on July 1 could take an exclusion for that year of $43,800 (since 6 of the 12 months were qualified exclusion months). The pro-ration is calculated down to the day.
You must file a timely return in order to claim the exclusion, and claiming the exclusion means that any tax advantages to income (like IRA contributions) are disallowed to the extent that earned income is excluded. Taking the exclusion also disqualifies you from the earned income credit.
Foreign Housing Exclusion and Deduction
In addition to the foreign earned income exclusion, taxpayers can also claim an exclusion for a foreign housing allowance. Congress has restricted the amount that can be claimed. The limit on the foreign housing exclusion is the following formula:
(30% of your own foreign earned income exclusion - 16% of the greatest possible exclusion)
The Treasury Secretary can prescribe higher housing exclusion amounts for more expensive countries. For a current list of these countries and levels click here.
If you are self-employed, you can deduct any foreign housing costs not already excluded by the earned income exclusion or the housing exclusion.
Amounts your employer gives you for lodging are not taxable, so they also cannot be excluded or deducted from income.
Any exclusion or deduction of housing naturally means that you cannot claim mortgage interest deductions or other tax advantages on that housing. No double benefit is allowed.
One of the biggest changes Congress has made in these rules is the so-called "inclusion amount." Under the prior law, the income and housing exclusions would be taken off of gross income, and whatever was left would have taxes owed.
Now, the amount of income that is left must be taxed as if the excluded income was never excluded. That means that fairly moderate-income taxpayers will face very high marginal tax rates on fairly low amounts of income.
These law changes make the foreign earned income and housing exclusions much less fair than they used to be. The changes won't affect moderate-income households or households without much domestic income, but it still creates a planning issue.
Another course is to claim the foreign tax credit. This will be a future posting.