Foreign Income Exclusion and Foreign Tax Credit

The IRS has multiple mechanisms in place to help avoid double taxation for individuals who are likely to be paying taxes to a foreign tax authority while living and working overseas in addition to any US expat tax that is due.  In order to take full advantage of these money saving opportunities, expats need to be aware of the Foreign Earned Income Exclusion and Foreign Tax Credit when it comes time to file.

The Foreign Income Exclusion allows taxpayers to deduct up to $92,900 of foreign earned income on their US taxes.  This is extremely important for US expats as many taxpayers can simply eliminate any income tax obligation they have on foreign earned income by applying this exclusion to their worldwide income.  To report this on a US expat tax return, fill out Form 2555 and attach it when you file with the IRS.  Note that you must qualify for either the Physical Presence Test or the Bona Fide Resident Test in order to qualify for this exclusion.

Equally important is understanding the Foreign Tax Credit.  Although many Americans fail to realize it, many foreign countries have significantly higher tax rates than those of the United States when it comes time to tax their residents’ income.  In order to reduce the chances of dual taxation, the IRS allows US expatriates to deduct taxes paid to a foreign country on a dollar to dollar basis with the Foreign Tax Credit.  This credit can be applied by attaching Form 1116 to your US expat tax return.

Many taxpayers overpay on their US expat taxes simply because they are unaware of these two big saving mechanisms or do not know how to take advantage of them. If you are unsure of how to attach these forms, seek expat tax advice.

Understand the Foreign Housing Credit

The Foreign Housing Credit is in place to help cover some of the costs of living and working overseas.  While it is easy to calculate the standard rate of 30% of the Foreign Income Exclusion, those individuals who live in countries with a more expensive cost of living are able to deduct a higher amount than individuals in a country with a lower cost of living.  For example, individuals living in Paris, Hong Kong or London are eligible for a much higher deduction rate than the standard rate due to the cost of living.   Ensuring that you are aware of these changing rates associated with each city you are living in could save you significant money on your US expat tax return.  This exclusion is also attached with Form 2555 and you must qualify under either the Physical Presence Test or the Bona Fide Resident Test.

Using the Best Exchange Rate

The IRS requires that all income is reported in US dollars on any US tax return.  What many taxpayers overlook is that one can actually save significant money by using the most advantageous exchange rate.

The IRS allows individuals to calculate the exchange rate using either the annual rate or the rate on the day of each individual payment or transaction.  While it may seem a bit of a task to calculate each individual exchange rate, doing so can save significant money for those individuals with high capital gains overseas or those who may receive bonuses throughout the year. 
For example, if you earn a bonus of 10,000EUR on December 24th and use the annual exchange rate for 2011, your bonus translates into an income of $13,928 on your US income taxes.  If you use the exchange rate on the day of the transaction, this same bonus is reported as $13,057, which allows you to avoid paying taxes on nearly $1,000 on income. The exchange rate savings can be quite significant for expats who receive large bonuses or lump sum payments on a given day in the year.

End of Year Tips

It is a good idea for individuals to take advantage of some of the tips the IRS gives taxpayers in order to save money at the end of the year.

Charitable donations to IRS approved charities can increase your total deductions – but they must be made by the end of the year in order to qualify.  Note that if you make a donation in December of 2011 on a credit card that isn’t paid until January of 2012, these donations are still eligible for donations on your 2011 tax return.

You should also evaluate your portfolio as capital losses can be taken against any capital gains on your tax return – but you must catch them in order to reduce the income you report!  This is a great piece of advice to reduce your tax liability on worldwide capital gains.

Don’t Pay Too Much for Your Tax Preparations!

While American expatriate tax returns can be confusing, many firms charge thousands of dollars for preparations that are then passed around to the most junior person in the office. Further, many companies will not disclose their prices or will charge a “per piece” preparation for the countless schedules and forms that are required for a US expat tax return.  Greenback Expat Tax Services can provide all the preparations you need for your US expat tax return with a hassle free process and reasonable, flat-rate pricing.