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Foreign Earned Income Exclusion

By Peter Jason Riley

To qualify for the foreign earned income exclusion, a U.S. citizen working abroad must have a "tax home" in a foreign country. If your tax home - where you have your regular or principal place of business or employment - is in a foreign country, and you meet either the bona fide residence test or the physical presence test, then you qualify for the foreign earned income exclusion. What this means is that you may exclude up to $80,000 for the year (computed on a daily basis). The exclusion is indexed for inflation and is $85,700 in 2007 and $87,600 in 2008.

To qualify under the bona fide residence test, you must be a bona fide resident of a foreign country or countries for an uninterrupted period that includes a full tax year. Since you're a calendar year taxpayer, this would include a January to December period. During a period of bona fide residence, you may leave the foreign country for brief or temporary trips elsewhere for vacations or business.

Even if you do not qualify under the bona fide residence test, you may still be eligible for the exclusion if you qualify under the physical presence test. Under this test, you would qualify if 330 full days out of any 12-consecutive month period are spent in a foreign country or countries. Physical presence that starts in the previous tax year but ends in the present year can be counted in determining whether you meet the 330 day physical presence test during a consecutive 12-month period for purposes of the exclusion for the present tax year.

If you meet the bona fide residence or the physical presence test, you may also exclude an amount based upon employer-provided foreign housing costs, although this usually reduces your foreign earned income exclusion.

You must make a separate election for each of these exclusions - they are not automatic.

Neither the foreign earned income exclusion nor the foreign housing exclusion, however, will serve to reduce the rate of tax on which you must compute your tax on income that is taxable. A "stacking rule" ensures that U.S. citizens living abroad are subject to the same U.S. tax rates as individuals living and working in the United States. Income that has been excluded from gross income as either foreign earned income or as a foreign housing allowance is included for purposes of determining the regular tax rate or, if applicable, alternative minimum tax.

For example, an individual with $80,000 of foreign earned income that is excluded, who also has $20,000 in other taxable, nonexcluded income (after deductions), would be subject to tax on that $20,000 at the rate or rates applicable to taxable income in the range of $80,000 to $100,000 (which is 25% for married individuals and 28% for singles, rather than the 10 and 15% rates at the bottom of the tax rate schedules).

You also should keep an eye on Congress. In an attempt to find tax dollars elsewhere during debate over the income tax rate cuts that took place in 2003, the Senate initially had voted to repeal the foreign earned income exclusion. Although this part of the 2003 tax bill never became law, we must continue to monitor events in Washington.

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