In Part I and Part II of this series, I introduced you to the Foreign Earned Income Exclusion and Housing Exclusion and Deduction, a list of definitions, the “mechanics” of the exclusions and deduction , explained how they reduce the income tax liability of qualified taxpayers, and discussed IRS Form 2555-EZ.
Now for the heart of it all — employing the earned income exclusion and the housing exclusions/deductions, and completing and filing Form 2555.
The same caveats of not being all-inclusive and being current as of the date of writing, as explained earlier in the other parts of the article, still apply.
If you have a personal tax question regarding this topic, please contact me here or use the similar tab just above this article.
Housing Exclusion or Deduction?
Part II ended with an unresolved question: Can a taxpayer employ both the housing exclusion and deduction? The answer, unfortunately, is “Probably not.” You may receive a benefit for housing expenses, but it will most likely be one or the other. Who decides? In a way, you do. I should say your means of earning the income does.
The housing exclusion is available to those who earn income as an employee for someone else. The housing deduction is available to self-employed individuals. Someone who earns income by both means (i.e., has a job and has a business on the side) can avail of both the exclusion and the deduction, but must allocate earned income. The taxpayer allocates income earned from the job to the exclusion calculation, and income earned from the business to the deduction calculation.
The Heart of It All
Generally speaking — Form 2555 is the form used for claiming the foreign earned income exclusion and/or foreign housing exclusion or deduction. If you will claim a housing exclusion or deduction, you must use Form 2555. The form itself is a little more involved than its “EZ-er” cousin, but then it serves a larger purpose.
It’s broken into nine parts and it handles almost every permutation or combination of exclusions and/or deduction. Let’s go through these parts; it’s the best way to gain an understanding of the “mechanics.”
Part I — This part, General Information, collects historical and current information that supports your eligibility to claim the exclusions and/or deduction. The questions are simple; answering them may require just a little thought and exercise of memory.
Part II & Part III — These parts will document your qualifying to claim the exclusions and/or deductions by either the Bona Fide Resident Test (Part II) or the Physical Presence Test (Part III). You select the part — either Part II or Part III, not both — that best documents your qualification. Answer all relevant questions, and insert “N/A” in those that do not apply to your situation. Additionally, enter “N/A” as the answer for the first question of the part you do not use, and skip the rest of it.
Part IV — Here is where “the numbers” start. This part documents your foreign earned income, broken down by methods of earning it.
NB — Most income tax treaties (including the USA-RP income tax treaty) stipulate that the sourcing of earned income is to the location where the taxpayer earns it. If you earn income in the Philippines then, by treaty agreement, it is “foreign earned income” for USA income tax purposes.
Earned income is not merely wages, salaries, commissions or business income. It includes other items such as:
- Non-cash income, in the form of lodging, meals, car or other property or facilities provided by your employer;
- Allowances, reimbursements or expenses paid on your behalf; and
- Other forms of earned income described in the Form 2555 instructions.
Adding all of these together provides you with your foreign earned income used to report and to calculate exclusions and deduction.
Part V — This is the easiest part of the entire form. It merely asks if you are claiming the Housing Exclusion and/or Deduction. If you are, you check the “Yes” box and continue to Part VI. If you answer “No,” you skip Part VI and go directly to Part VII.
Part VI — Directed here by the answer provided in Part V, this part seeks your qualified housing expenses, where you incurred them, and over how many days in the year over which you incurred them. Did I mention the housing exclusion and/or deduction is limited? It is. The IRS assigns a per diem rate (found in a table at the end of the instruction booklet) to the country or area where you incurred your expenses. Multiply this rate by the number of days provided earlier. So you are limited to either your actual qualified expenses or to the per diem limit, whichever is smaller.
Back in the second part of this article, I mentioned a limit to the foreign earned income for which you can claim the exclusions and deduction. For 2009, that limit was $91,400; your total exclusions and/or deduction cannot exceed that amount. It is here in the form’s Part VI that you calculate the housing expense portion of that limit. The calculation is straightforward, albeit strange looking. Multiply another per diem rate ($40.07 for 2009) by the number of days provided earlier. If you incurred the expenses over the entire year (365 days), the amount is $14,624. Subtract this amount from your limited expenses describer in the previous paragraph.
If the result is zero or less, you are finished with the housing parts – you can’t calculate a housing exclusion in Part VI and you can’t calculate a housing deduction in Part IX. You do not complete the rest of Part VI and move directly to Part VII. If the result is greater than zero, then you apportion that result to arrive at your housing exclusion. Calculate the rate of apportionment by dividing the employer-provided earned income by your total foreign earned income calculated in Part IV. Multiply this rate against the result of the limited expense calculation described in the last paragraph to provide the amount of housing exclusion that eligible taxpayers may claim.
Even if you are self-employed, you must complete Part VI to provide the amounts reported in the remaining parts of the form.
Part VII — Everyone completes this part – it calculates the Foreign Income Exclusion. Again, the calculation is straightforward but strange looking. All it really does is calculate this exclusion as equal to the limit ($91,400) or an amount apportioned to the number of qualifying days (the same number of days reported in Part VI, if you completed that part) for the exclusion that fall in the tax year (2009).
Part VIII — Another easy part, this one merely adds your foreign earned income exclusion and housing exclusion amounts together and has you subtract the deductions allocated to this total. The result is the amount you will actually exclude from your income. Here, the form tells you how and where to enter them on your Form 1040.
Part IX — This final part is for the self-employed – it calculated the Housing Deduction. Again, it’s straightforward but strange looking. The first strange looking item is a provision printed at the top of this part. It says that you can complete this section only if you meet two calculated criteria. If you cannot, you won’t have a housing deduction. The criteria are:
- Your limited housing expenses, as calculated in Part VI, are larger than the potential housing exclusion calculated in that same part; and
- Your total foreign earned income, as calculated in Part IV, is larger than the sum of the potential foreign income exclusion and the housing exclusion, as calculated in Part VIII.
If you meet these two criteria, then you find the differences between the amounts listed for each of the criteria, and use the smaller of these two differences to calculate your housing deduction. This is a simple calculation. You merely add any unused housing deduction from the prior tax year (2008). This is your housing deduction.
Lastly, this part instructs you on the how and where to enter the housing deduction in your Form 1040. That’s it!
The Foreign Earned Income Exclusion and Housing Exclusion/Deduction are one of two tools devised to lower your U.S. income tax liability. It does so by lowering your taxable income by amounts attributable to income earned in a foreign country. Calculation and reporting of the exclusions/deduction occur on Form 2555, or Form 2555-EZ if you employ the foreign income exclusion alone.
The second tool, mentioned way earlier in a different part of this multi-part article, is the use of the Foreign Tax Credit, as calculated and reported on Form 1116. Since the Foreign Earned Income Exclusion and Housing Exclusion/Deduction may not eliminate all foreign income taxable in the U.S., you can eliminate or significantly reduce the U.S. income tax on the remaining foreign earned income by applying this tax credit. You qualify for this credit if you paid taxes on that remaining foreign earned income to a country with which the U.S. has an income tax treaty taxed it.
If you haven’t figured it out already, here’s the Bottom Line: These are the methods available to you to prevent the double taxation of your income by two or more countries.
Some tax agency, whether the IRS or its counterpart in a foreign country, will receive income tax revenue from you. One agency may receive all, or each will receive its apportioned part. You will pay income taxes, however. The wise move is to make sure you only pay them ONCE.
IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, I must inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.