You took that great job in London and it has done wonders for your career as well as your bank account. It could also be a boon to Uncle Sam.
Under U.S. tax laws, the worldwide income of any U.S. citizen or resident alien is subject to tax. It doesn’t matter if you’re living in the United States or overseas, or the money came to you as wages, independent contractor payments or unearned income from investments, pensions, rents or royalties. The Internal Revenue Service is due its legal percentage.
There is a bit of a break for U.S. taxpayers who live abroad and meet certain requirements. These worldly citizens may be able to exclude all or a portion of their foreign earned income from the American tax code.
Unfortunately, though, some changes to the housing portion of this tax benefit mean that some U.S. workers with international postings will likely be using any tax savings to pay for housing costs that now get less favorable treatment.
Good and bad foreign income news
First, the good news. The amount of foreign income a worker can exclude from U.S. taxation on a 2009 return is $91,400, up from the prior year’s $87,600. The low inflation rate means that for 2010, the excluded income amount edges up to just $91,500.
Now, for the bad news. While the excludable-income amount is slightly higher, a law enacted in May 2006, the Tax Increase Prevention and Reconciliation Act, or TIPRA, changed the way any tax on remaining foreign income is figured.
- Good and bad foreign income news.
- Overseas housing limits.
- Filing methods remain the same.
- Different tax rules for U.S. possessions.
Before TIPRA, after an overseas worker subtracted the exclusion amount, the worker was then able to figure U.S. taxes based on the remaining income. Now, however, regardless of the final taxable dollar amount, it is taxed as if it were still in the bracket it would have been in before the exclusion was allowed.
This means that expatriate workers will lose the tax-reducing value of the lower brackets in our progressive tax system. For example, if you make $100,000 overseas, your tax bracket is based on that amount, not just on the $8,600 you have after subtracting the $91,400 exclusion from your overall $100,000 income. So instead of figuring taxes on the $8,600 by beginning at the 10 percent bracket and working up through the progressive tax scale, the foreign-based worker would calculate his or her tax bill by starting at the 28 percent bracket into which the pre-exclusion income amount falls.
Overseas housing limits
Taxpayers who qualify for the foreign income exclusion also might be eligible for a tax break on a portion of overseas housing costs. But the changes in TIPRA greatly reduce this benefit for some workers abroad.
Employees outside the United States still can exclude from U.S. taxes a portion of salary that goes toward overseas lodging. For the self-employed, foreign housing costs still can be claimed as a deduction. But the allowable housing amount is calculated using a percentage, 16 percent, of the current exclusion amount. The worker must also take into account the new law’s 30 percent limit of the income exclusion.
When all the numbers are run, the bottom line is that for 2009 taxes, the most a worker abroad can exclude for housing costs is $27,420.
International tax accountants say this new housing allowance cap could cause U.S. taxpayers working in countries with expensive housing markets to face substantially higher taxes on their overall foreign compensation.
The IRS heard the protests and implemented a change in housing limits for some areas. For 2009, the maximum limitations on qualified housing expenses incurred in more than 300 foreign locations can be found in the table beginning on Page 5 of Form 2555 instructions. That listing shows countries that the U.S. State Department has identified as having high housing costs. Based on this data, the housing expense limits in those areas have been adjusted accordingly.
Remember, though, that these figures are not the final amount of housing costs you can exclude from your income. When you file your tax forms, you’ll have to use the table amount in conjunction with the 16 percent and 30 percent limits to arrive at the actual amount you can exclude.
Filing method remains the same
While income and housing exclusion amounts have changed, eligibility requirements to claim them have not. In order to exclude any overseas earnings from U.S. taxation, you must meet two tests:
- You have a tax home in a foreign country.
- You meet either the Internal Revenue Service’s bona fide residence or physical presence requirements.
Basically, your tax home is your regular or principal place of business, employment or post of duty. The IRS wants to be sure that you actually moved abroad rather than simply traveled there periodically to earn money. And you’re not totally off the tax hook. If the foreign country has income tax laws, you cannot claim to be exempt from them.
The second test requires you to establish a genuine home in the country for a full tax year or, failing that, spend at least 330 days abroad earning your income.
As for your abode abroad, expenses you may count include rent, repairs, utilities (other than the telephone), real and personal property insurance, furniture rental and parking fees. But don’t try to slip that villa on the Cote d’Azur past the IRS. The agency specifically says lavish or extravagant foreign housing expenses are not allowable.
File Form 2555 along with your U.S. tax return to claim the foreign-earned-income exclusion and the foreign housing exclusion or deduction. If you don’t have any housing expenses to claim, you may be able to file the simpler Form 2555-EZ.
Different tax rules for U.S. possessions
One final warning: Don’t jump at that job in St. Croix thinking it will get you off the tax hook while simultaneously improving your tan.
American Samoa, Guam, the Commonwealth of the Northern Mariana Islands, the U.S. Virgin Islands and Puerto Rico are U.S. possessions, not foreign countries under the tax laws.
They have their own independent tax departments. If you have income from one of these U.S. possessions, you may have to file a U.S. tax return only, a possession tax return only or both returns.
In some cases, you may have to file a U.S. return, but be able to claim a possession exclusion similar to the foreign-earned-income exclusion. Information on the available tax exclusions and requirements can be found in IRS Publication 570, Tax Guide for Individuals With Income From U.S. Possessions.