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International Tax Q and A
March 25, 2014
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Tax incentives for U.S. citizens living abroad

Normally, U.S. citizens and residents are taxed on their worldwide income. But to make U.S. businesses more competitive abroad Congress desired to make the use of U.S. employees abroad less expensive. Consequently, U.S. citizens and residents who work abroad have been able to exclude from gross income foreign source earned income and certain excessive housing cost amounts.

The foreign income exclusion is basically a substitute for the foreign tax credit on that income, but applies whether or not the foreign country taxes the income. To be eligible the taxpayer must be a “qualified individual.” A qualified individual is one who is a bona fide resident of the foreign country for at least a taxable year or is present in a foreign country for at least 330 days during any consecutive twelve months and the taxpayer’s tax home is in the foreign country. The exclusion is limited to compensation for personal services actually rendered while overseas not exceeding a fixed amount indexed for inflation set by Congress. Under this exclusion, where both personal services and capital are material income-producing factors, not more than 30 percent of the net profits are treated as earned income subject to the exclusion.

In addition to the foreign earned income, a qualified U.S. taxpayer can exclude for tax purposes a housing cost amount. The base housing amount used in calculating the foreign housing cost exclusion in a taxable year is 16 percent of the amount of the foreign earned income exclusion limitation, multiplied by the number of days of foreign residence or presence in that year. Certain expenses are ineligible for the exclusion, which include: the costs of purchasing a house or apartment, capital improvements, furniture, mortgage interest, property taxes, household laborers, and any costs that are “lavish and extravagant.”