Although U.S. citizens are taxed on their worldwide income, substantial tax benefits apply to U.S. taxpayers who spend all or part of the tax year overseas. The Internal Revenue Service (IRS) foreign-earned income exclusion allows the deduction of up to $87,600 of income earned overseas. There is also a housing exclusion and a deduction for taxes paid to foreign governments. Unless you earn well over $100,000 a year (or a pro rata portion), it is likely you will be able to deduct all your foreign-earned income.
Foreign-Earned Income Exclusion
The foreign-earned income exclusion allows you to deduct $87,600 from any income you earned while physically present or a bona fide resident abroad, prorated to the proportion of the tax year you spent abroad in one of these two statuses. For example, residing abroad for six months would entitle you to a maximum deduction of $43,800.
You may deduct from your taxable income --- up to a certain maximum --- your entire housing amount for a foreign residence, as long as this housing qualifies as an employer-provided benefit (as opposed to housing paid for with self-employment income). Under limited circumstances, you may also deduct housing expenses for a second foreign residence. This exclusion includes utilities, insurance and even telephone bills. Limits apply to the simultaneous use of both the foreign-earned income exclusion and the housing deduction.
Tax Treaty Benefits
The U.S. has bilateral tax treaties in place with most foreign nations. If you paid taxes to a foreign government during the tax year, you may be able to take a tax credit for these payments (up to established limitations). Simply complete IRS Form 1116. If this credit is not fully used in the tax year in which it was generated, it may be carried over to succeeding tax years.
Waiver of Exclusion
The foreign-earned income exclusion must be specifically invoked on Form 1040 before it will become applicable. Once chosen, it will automatically apply to all succeeding tax years until revoked. Some expatriate taxpayers, noting that all their income is excludable, fail to file tax returns while living overseas. This is dangerous because if the exclusion is not initially invoked, it is considered waived. Because of this, an expatriate taxpayer who stops filing tax returns upon moving overseas will lose this exclusion and end up owing full taxes to two governments. On the other hand, if he files a return his first year, invokes the exclusion, and fails to file thereafter, the exclusion will not be considered waived.
U.S. citizens and long-term residents who renounce their citizenship or abandon their U.S. residences, respectively, will continue to be taxed on their worldwide income (subject to the above exclusions) for the following 10 tax years if the IRS rules that the purpose of such renunciation or abandonment was to evade federal taxes. This law contains many additional intricacies and loopholes (see References).
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