US Tax Considerations
This time of year, whether you want to or not, you must eventually think of doing your taxes. Some people will prepare their own returns, others will hire a professional. Either way, if you want to get the best tax answer you need to be informed and organized. Many people fall into tax traps or ignore potential deductions simply because they did not know any better. The goal of this article is to inform you, organize you, and best of all, save you money!
Many people do not realize that US Citizens and Green Card Holders working overseas are required to file a US Tax Return even though they may be considered a tax resident of another country. Additionally, they may have come from a state that still considers them to be resident even while on assignment abroad! Breaking Residency is rather involved and will be discussed separately.
There are 3 ways to eliminate the double taxation of your income by your new country and the US: the Foreign Earned Income Exclusion (FEIE), the Foreign Housing Exclusion/Deduction (Housing exclusion) and the Foreign Tax Credit (FTC). You can use them separately or together to get the best answer.
Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion will exclude up to $80,000 of earned income (wages or self-employment income) for tax year 2004. For example, if you moved abroad for a three year assignment on July 2nd of 2004, you would be able to exclude up to $40,000 of earned income. The little known tax tip here is that unused exclusion can be carried forward for 1 year. If, in the prior example, you only utilized $25,000 of the $40,000 worth of FEIE that you were eligible for, then you could carry that additional $15,000 of potential exclusion over to 2005. You become eligible for the FEIE upon meeting one of 2 tests, the Physical Presence Test (PPT) or the Bona Fide Residence test (BFR).
PPT is primarily used for transition years, when you first go abroad and repatriate back to the US. It requires that you physically spend at least 330 days out of any consecutive 365 day period abroad. This creates a 35 day window known as the "slide period." For each day you spend in the US during that 365 day period, your "slide period" of 35 days is reduced. By minimizing the number of days you spend in the US for the first year after you've gone on assignment or the year before repatriation, you can gain a tax benefit. This may best be shown by example.
Betty goes on assignment from Boston to Paris on 7/1/2004. She stays on assignment through 7/1/2004. She goes back to the US on 1/2/2005 for a 10 day trip and doesn't take another until 2003. As she had less than the 35 days in the US from 7/1/01-7/1/02, we can use the slide rule to increase her FEIE by 25 days (35-10 in the US). As a result in 2004, the potential FEIE she can take has been raised by more than $5,300. Had Betty not traveled to the US at all during her first year abroad, she could have used the full slide rule to exclude $7,479! The problem is that most people don't think about PPT when planning their trips home and thus waste perfectly usable exclusion.
The Bona Fide Residence test is easier for most to understand, requires less planning and thus is the test most people choose to use. It requires that you spend a full calendar year with your tax home abroad. Unlike PPT, BFR does not count how many days you traveled back to the US for determining your eligibility,merely that your tax home was overseas for at least one calendar year. An example follows: Betty goes on assignment from Boston, MA to Paris France on 7/1/2004. She only works overseas but makes frequent trips back to the US to visit friends & family for 50 days per year. She stays on assignment through 7/1/2004. Betty meets the requirements of the Bona Fide Residence rule on 1/1/2003 as her tax home was abroad for all of calendar year 2005. She will be allowed to use the Foreign Earned Income Exclusion for half the year in 2004, all of 2005, 2003 and half of 2004 in this scenario. Had Betty planned her trips better, she could have increased her FEIE in 2004 and 2004 by 19% by using PPT.
Foreign Housing Issues
Your Foreign Housing contains several benefits that go unused by taxpayers due to improper record keeping, making incorrect assumptions, and poor planning. Alternately, there are some nasty traps here as well. Most taxpayers assume that the amount they received for the rental portion of their housing allowance (if they had one) and their housing expenses reported for tax purposes should be the same. That is far from correct! A little record keeping here will increase their exclusion and lower the US tax burden considerably.
The Housing Exclusion allows you to deduct the cost of reasonable housing that exceeds a Federally determined housing norm. This includes your Rent, Utilities, and other operating expenses related to the housing (i.e. TV taxes imposed in some countries). It does not allow you to deduct other separately allowed deductions allowed under the Internal Revenue Code, or excessively lavish housing. For example, if you purchase a home during your assignment overseas, you will not be allowed a Housing Exclusion as the Mortgage Interest and Real Estate Taxes are already allowed as itemized deductions.
Purchasing a home overseas can trigger some serious tax traps. The first, as we already mentioned is that you can no longer take the Housing Exclusion. This may not sound all that bad to you as you get to deduct the Mortgage Interest and Real Estate Tax while building equity just like at home in the US. However, the amount you pay for your utilities and other operating expenses of managing your home is no longer excludable. Furthermore, unlike the Housing Exclusion, these deductions can be REDUCED if your Adjusted Gross Income (AGI) is more than $132,950. If you are being tax equalized or tax protected, some of this erosion of your itemized deductions may be borne by your employer.
The next tax trap related to owning a home overseas is created when you sell your home or refinance your mortgage. At the time of either of these events, you will be required to recognize the "gain," if any, on repayment of the mortgage. That is because the US tax system relates to everything in terms of US dollars. Therefore, unless your foreign mortgage (or any other foreign loan) is based on US dollars, there is a potential for a currency "gain" upon paying it off. For example, Al buys a home in Paris, France on 1/1/1998 for 500,000 French Francs (FF). His mortgage is 400,000 FF. The exchange rate on that date is 4FF to 1 US Dollar (USD). Due to lower interest rates, he decides to refinance on 1/1/2005 when the exchange rate is 5FF to 1USD. The US tax system looks at it this way, a liability of $100,000 (400,000FF divided by 4FF/1USD) was paid off with $80,000 (400,000FF divided by 5FF/1USD). Therefore, you have a taxable gain upon refinancing of $20,000. However, if this refinancing had created a loss it would NOT be deductible. Although this seems highly inequitable, it is the law and a nasty tax trap for the unwary.
You may also wish to speak to your employer or a tax professional in your host country about your foreign housing. In some countries, if the employer pays the landlord directly, the rent can be excluded from local taxation.
The Foreign Tax Credit
The Foreign Tax Credit can be used to reduce your US liability by giving you a dollar-for-dollar credit, not to exceed your US liability. The FTC will exclude taxes related to either exclusion mentioned above to avoid giving you a double benefit and also factors out portions of certain itemized deductions or adjustments to gross income for the same reason. Furthermore, the Foreign Tax Credit may very well get limited by the Alternative Minimum Tax. All these factors make the Foreign Tax Credit a rather complex area. A more detailed discussion will be presented separately.
Most Americans are used to making donations to various charities (churches, temples, universities, other civic foundations, etc.) and this is a wonderful thing to do. The problem is that unless the charity, church, temple or other non-profit organization you are donating to is a US qualified charity, then the donation will not be deductible. For example, Bob goes on assignment to Poland. He is used to tithing to his church and donates a total of $20,000 per year to St. Mary's Church of Warsaw, while on assignment. St. Mary's of Warsaw is not a US qualified charity, nor an affiliate of one. As such, his donation is not deductible on his US return. By all means, please continue to support charities while on assignment, just do so with a little knowledge and planning.
Additionally, when you initially go on assignment and leave the US, you usually end up going through all of your belongings and find several items in good condition that you no longer want. By giving these items to a Salvation Army, Goodwill Industries, or another local charity you will be doing something beneficial to others and if you remember to get a receipt, save a little tax money in the process.
The number one reason that people do not minimize their tax burden is poor records. You should always keep a running record of all of your expenses throughout the year and properly categorize them. You don't need to purchase a recordkeeping software program, but it helps. Another alternative is keeping a spreadsheet for your financial records. It functions much the same way and lets you customize it to your needs.
While on assignment, you also need to keep track of your travel calendar and workdays. This is so you can properly source your income. You income needs to be sourced between US or Foreign for many purposes, the FEIE, Housing Exclusion, and FTC. Furthermore, any days in the US need to be sourced for tax purposes between the states in which you worked. The best way to keep track of this is with a monthly journal or a spreadsheet. It may be a pain to update once a week, but it will save you a lot of time, and hopefully a lot of money in the end.
Dean Demos has been a tax professional for over 17 years, specializing in US Individual Taxation. He has managed accounts in the Big 4's Personal Financial Services and International Assignment Solutions departments and specializes in Expatriate, Foreign National & High Net Worth Individual Tax. He can also help companies meet the needs of running their Expatriate programs with tax compliance, consulting and planning for their international population.
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