Retiring abroad can have some terrific benefits that include a lower cost of living, better weather, and exotic cultures and scenery. But what if you’re still working? Is there any benefit to working abroad? There certainly can be if you meet certain qualifications. In the following paragraphs, I will show you what Foreign Earned Income Exclusion, Foreign Tax Credit (or Deduction) and Foreign Housing Deduction/Exclusion are, what forms needed and how to choose among these tax benefits.
Foreign earned income exclusion (FEIE)
U.S. citizens are taxed on income they earn anywhere in the world. However, if you meet two qualifications, you can take a tax exclusion on your income tax return for the income you earn abroad. As of 2016, this exclusion can be as much as $101,500.
This exclusion is per person, so if a married couple are both working abroad, each one can claim the full exclusion.
The exclusion is available only for wages or self-employment income earned for services performed outside the U.S. Only individuals are eligible for the exclusion, not businesses, and the individual must meet one of two requirements:
1. They must be a bona fide resident of a foreign country for a period that includes a full U.S. tax year, or
2. They must be outside the U.S. for 330 days in any 12-month period.
That means an expatriate making $75,000 overseas would pay no taxes, although he or she still must file IRS Form 1040 and claim the exclusion. If the expatriate makes $105,000, tax must be paid on the difference between his or her salary and $101,300, or $3,700. But if the expatriate visits the United States for more than 35 days in that period, the benefit is lost.
To claim Foreign Earned Income Exclusion (FEIE), you must use form 2555. Up to two Forms 2555 can be e-filed per return, one for each taxpayer.
Foreign tax credit (or Deduction)
If you’re also paying taxes in the United States, that would be double taxation. So the U.S. tax code allows you to take a foreign tax credit. Under this section of the tax code, you subtract the lower of the tax rates from the higher. In effect, you pay only the higher of the two tax rates, split between the two countries.
Here is an example:
Say you lived and worked in London in 2016 and made $180,000 a year. You can use the Foreign Earned Income Exclusion to exclude $101,300 of that income from taxes. The remainder -- $78,700 -- is subject to U.S. and U.K. tax. Your income tax rate in the United Kingdom could be 20 percent and your American rate 30 percent. You pay the British tax, and subtract that rate from the American tax, so you pay just 10 percent of the $79,200 in American taxes.
You must choose to take either a credit or a deduction for all your qualified foreign taxes. For those who itemize deductions on Schedule A Line 8 of Form 1040, taking a deduction for foreign taxes paid is the easiest way to go.
However, an itemized deduction only reduces your taxable income, whereas an income tax credit, which can be claimed on form 1116, can provide a dollar-for-dollar reduction of your actual tax liability.
For example, if you're in the 33% income tax bracket, a $200 deduction would only reduce your taxes by $66 (assuming full deductibility), whereas a tax credit would provide a $200 reduction in tax liability (if you are eligible for the entire credit).
Generally, it is more beneficial to claim foreign taxes paid as a credit rather than claiming a deduction. You may wish to do a comparison to determine which is best in your situation.
Foreign Housing Deduction/Exclusion
In addition to the foreign earned income exclusion and foreign tax credit (or deduction), you also can claim an exclusion (for salaried) or a deduction (for self-employed) from your gross income for your housing expenses. Housing expenses include rent, fair rental value of housing provided in kind by your employer, repairs, utilities (other than telephone), insurance, parking, among other items.
Housing expenses do not include expenses that are lavish or extravagant, deductible interest and taxes, cost of buying property including principal payments, domestic labor (maid, gardeners, etc.), improvements that increase the value or prolong the life of property, purchased furniture or depreciation.
The base housing amount is 16% of the eligible amount of foreign earned income exclusion. For example, if you are able to exclude the maximum for 2016 or $101,300, the base amount is $16,208 or $44.41 per day. This amount is the portion that cannot be excluded- think of it as the money you would typically have spent on housing in the United States.
There is also a limit on housing expenses. The amount of qualified housing expenses eligible for the housing exclusion and housing deduction is generally limited to 30% of the maximum foreign earned income exclusion computed on a daily basis (for 2016, this would be 30% of $101,300 or $30,390, or $83.26 per day). However, the limit can vary wildly depending upon the location of your foreign tax home.
In 2006, the IRS, Treasury Department along with the State Department began recognizing that certain locations carry a much higher cost of living, and therefore needed to be factored into expatriate and per diem calculations. There are over 400 countries and specific cities that are deemed high-cost areas. The latest list is detailed in IRS Notice 2016-21
How to choose among these benefits
You may use Form 2555 and Form 1116 on the same return, but cannot use the same earnings (and taxes paid relating to those earnings) on both forms. For example, if your foreign earned income is $119,600, you can only exclude foreign earned income up to $101,300 on the Form 2555 which will reduce your taxable income on the return. The remaining foreign earned income of $18,300 may be used on Form 1116. You would need to determine which amount of the foreign taxes paid are allocable to the $18,300 and only use this portion of the foreign taxes in the calculations on Form 1116.
On the other hand, if you would like to claim a foreign tax deduction instead of the foreign tax credit, then you would use Schedule A instead of Form 1116. Please note: IRS Publication 514 specifically states "as a general rule, you must choose to take either a credit or a deduction for all qualified foreign taxes." This means you cannot take a foreign tax credit and deduction on the same return. To clarify, you can use Form 2555 and Form 1116 on the same return, and you can use Form 2555 and Schedule A on the same return; however, if you claim a deduction you cannot claim a credit and if you claim a credit, you cannot claim a deduction