One of the most puzzling calculations for US taxpayers comes through foreign earned income taxes. All US citizens and residents who work or do business abroad need to file for US tax returns. The passive income such as dividends in a foreign market investment must also be reported in your tax returns with the IRS.
Underreporting or deducting the wrong proportion of foreign expenses may also get an audit letter from the IRS. IRS states two basic criteria to test your foreign earned income. That income can then be adjusted for tax credits, deductions, and proportion.
Some key criteria points for US tax filers as overseas workers / businesses:
You are a US citizen, resident, or a US entity and work abroad for an entire year or 330 days in a 12 month period
Your foreign income is equal to or above $107,600 (for the year 2020)
You have a tax home in the foreign country of your work
The US has a tax treaty with your foreign country of work
Bona fide Residence Test
If you complete a full tax year in a foreign country uninterrupted, you will qualify as a bona fide resident of that country. All your foreign income must be reported to the IRS. You can then claim tax deductions or exemptions on that foreign income.
If you do not work abroad for a full tax year, or 330 days in 12 months, your income must be reported under the worldwide income with the IRS.
What If You File Taxes in the Foreign Country?
Every country has a different tax collection system. Some countries do not tax passive income, while some have double tax treaties that lower the tax burdens. The US also has double tax treaties with many countries. That means even if you are filing taxes in a foreign country, you still need to report that income to the IRS.
Even if your foreign government does not tax your income somehow, your foreign earned income will be reported with the IRS.
Foreign Tax Credit
You can file for a foreign tax credit on form 1116 to claim the benefits. The foreign tax paid will reduce your total payable tax to the IRS. However, do not assume that a foreign tax payment can reduce your US income tax. Both income taxes will need to be paid.
The biggest advantage of claiming a foreign tax credit is that it reduces your total tax liability on a dollar-for-dollar basis. Exemptions and deductions reduce your income slab only. Also, you can carry forward any excess foreign tax credits for the next year.
Foreign Earned Income Deductions and Exemptions
Here is the caveat though, you can either claim a foreign tax credit or go for the income and expense deductions. You cannot take both advantages at the same time.
The foreign income exclusion amount is inflation adjusted by the IRS each year. If you file jointly for the tax returns, you can claim the foreign tax exclusions for the double of that limit.
The qualified earnings you can exclude from your income are:
$107,600 for the year 2020 - $105,900 for 2019
$215,200 for Joint Filing
If your foreign annual income does not meet the threshold amount above, you will still need to report it to the IRS. It will be considered as part of your total worldwide income.
Foreign House Deductions
Your foreign housing expenses are tax-deductible from the foreign income you report. The maximum limit of the foreign housing deductions is 16% of the maximum exclusion amount. If you lived abroad for less than a calendar year, then deduct only for the proportion of the period you lived abroad. For example, deduct for 16% × (107,600) first, $17,216, and then for say 230 days in the year that will be $10,848.43 in this case. (17,216 ÷ 365 = 47.16 × 230 = 10,848.43)
Make sure to deduct the qualified foreign housing expenses only. Personal expenses like meals are not deductible.
Foreign income tax credits and deductions are only for the qualifying overseas workers. Mistakenly, US citizens working abroad but keeping abode in the US, often deduct foreign income tax credits. The foreign tax credits and deductions apply to US citizens that can be regarded as bona fide foreign residents.
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