Foreign Earned Income Exclusion: The International Conspiracy to Steal Your Money

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:

1. Your tax home (place where you work) must be in a foreign country
2. You must have foreign earned income (does not include lodging, meals, fringes)
3. 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.

Inclusion Amount

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.

Alternatives

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.

Comments

[andy cabrera]

if i own a second home in a foreign country, is mortgage interest deductible?

[Wayne Herbert]

The changes to the inclusion amount represents a fraud of the most underhanded sort.

My wife has lived and earned income in the US while I have been earning income from a foreign corporation while living in Singapore. Thus, I qualify for the foreign income exclusion while she does not.

The obvious effect of this change is that my wife's entire income is taxed at a significantly higher rate in 2006 than it was in 2005. So while the IRS _says_ they are giving me an exclusion they are actually taxing my foreign income as the difference in taxes that my wife would pay excluding or not excluding my income. Worse, if I take the foreign income exclusion I cannot even take a tax credit for foreign taxes paid.

This is a patently undair situation and should certainly be protested by all expatriates with foreign income.

Thank you.

[Susan Reed]

Mr. Herbert,

I share your pain. I have worked as a contractor with the Federal Government in Germany. I have to pay German taxes because my job does not qualify for the German Technical Expert Status. I filed a 2555 for the Foreign Income Exclusion. My husband is a federal government employee whose wages are fully taxable and we suffered a substantial increase in taxes due to the new law. I recomputed my taxes using the Foreign Tax Credit, but that did not help because AMT kicked in. I recomputed my taxes Married Filing Separately, but again was hit with AMT. I am now, in essence, doubly taxed.

The irony of this is that if my spouse were also a contractor, we would not have suffered a significant increase in tax. But if he is a federal government employee or military member, we have this increased tax burden.

I am an IRS Enrolled Agent and have dealt with taxes for many years. Usually, there is some equity in IRS taxing situations, but I see none here. I feel that the new law was not well thought through. I think it would be more equitable to calculate the increased tax rate only on the additional income attributable to the spouse who claimed the Foreign Earned Income Exclusion.

[Susan Reed]

Mr. Herbert,

I share your pain. I have worked as a contractor with the Federal Government in Germany. I have to pay German taxes because my job does not qualify for the German Technical Expert Status. I filed a 2555 for the Foreign Income Exclusion. My husband is a federal government employee whose wages are fully taxable and we suffered a substantial increase in taxes due to the new law. I recomputed my taxes using the Foreign Tax Credit, but that did not help because AMT kicked in. I recomputed my taxes Married Filing Separately, but again was hit with AMT. I am now, in essence, doubly taxed.

The irony of this is that if my spouse were also a contractor, we would not have suffered a significant increase in tax. But if he is a federal government employee or military member, we have this increased tax burden.

I am an IRS Enrolled Agent and have dealt with taxes for many years. Usually, there is some equity in IRS taxing situations, but I see none here. I feel that the new law was not well thought through. I think it would be more equitable to calculate the increased tax rate only on the additional income attributable to the spouse who claimed the Foreign Earned Income Exclusion.

[Alan Jackson]

I'm in a similar situation here in Germany, working for a local firm and my American wife for the US military. Although I'm a British citizen my wages are taxed not only by the German authorities but by the IRS as I am a Green Card holder, thus increasing my wife's tax bill substantially.
Forgive my ignorance, but is the amount of foreign earned income to claimed as an exclusion defined as the amount earned before or after the foreign tax has been paid? My wife thinks its after tax, but then she would, wouldn't she!

[Helen]

I am an American citizen working for the U.S. forces and married to a German citizen - a non-resident alien. The Germans changed their tax system several years ago (retroactively) to do essentially the same thing that the U.S did recently - "exclude" my income but tax husband's income at a much higher rate. This means that we now are being slammed in taxes by two countries. I wanted to take the foreign income credit rather than the exclusion. Turbo tax is trying to force me to take the exclusion. A look at the IRS pamplets is not totally clear on this point. Has the choice of taking the foreign tax credit in lieu of the exclusion disappeared. It would be much more advantageous for me and many others. Thanks.

[David Alderman]

I work in South Korea. I know I can file a tax exclusion form 2555. I did that last year. The problem this year is that I want to contribute to my ROTH IRA. If I file the form 2555 the government considers me to have no earned income and can not make a 2007 contribution. Is there a way I can still contribute to my ROTH IRA??? The only thing I can think of is not filing form 2555 and paying double taxes allowing me to have earned income which would allow me to contribute.

[Katherine]

I'm trying to forecast how much my taxes I will owe since I qualify for the foreign income exclusion under the new law. Do you take the taxes you would pay on the total amount of income and subtract the taxes you would pay on the excluded income (87,500) and that would give you the tax liability. I haven't been able to find any calculators on line to help with this. Any suggestions?

[Ruben D. Puga]

1. Am I entitled to any type of " foreign earned income exclusion" on my US retiree pension while residing in Spain?
2. Could I take a tax credit for foreign taxes paid on my US Income?
Appreciate your comments,
Best regards,

RD Puga