Although U.S. expatriates (U.S. citizens and resident aliens) either temporarily or permanently work in another country, they continue to be subject to U.S. income tax. However, because they are also often subject to taxation by the country in which they reside, the U.S. (per IRS Code Section 911) allows certain individuals to elect to exclude all or part of their foreign earned income, as well as to exclude or deduct a certain amount of their housing costs. This article will discuss the tax relief given for U.S. expatriates’ housing costs.

There is both a foreign housing exclusion and a foreign housing deduction. The housing exclusion is for employer-provided amounts. (“Employer-provided” is not only restricted to employer-provided housing allotments, however. See the section “Foreign Housing Exclusion” below for an explanation.) The housing deduction applies to individuals who pay for their own housing with self-employment earnings.

The calculations required for determining the taxable income of expatriates, as well as their housing cost amounts, are quite complex. The rules are further complicated due to several limitations that require additional calculation. To ease the complexity, having good income tax planning software is often recommended. Let’s look at why this is so.

Excludible/Deductible Housing Cost Amount

Housing expenses include rent; repairs; utilities other than telephone; real and personal property insurance; nondeductible occupancy taxes; rental of furniture; and residential parking.

The eligible housing cost amount is the individual’s total housing expenses (subject to certain limitations) for the year less the base housing amount. The “base housing amount” (for tax years beginning after 2005) is determined by multiplying:

A. 16% of the maximum foreign earned income exclusion amount* (computed on a daily basis) in effect for the calendar year in which the tax year begins, times

B. the number of days within the tax year that are within the period of foreign country residence or presence that qualifies the employee for the Section 911 exclusion.

* The “maximum foreign earned income exclusion amount” is $80,000 per year for most locations, as adjusted annually for inflation for tax years beginning after 2005. (The exclusion amount was $82,400 in 2006 and, in 2007, it is $85,700.) However, both the exclusion amount and the deduction amount are further limited to:

A. 30 percent (as adjusted in Treasury guidance as deemed necessary based on geographic differences in housing costs relative to U.S. housing costs) of the maximum foreign earned income exclusion amount (computed on a daily basis) in effect for the calendar year in which the tax year begins, times

B. the number of days within the tax year that are within the period of foreign country residence or presence that qualifies the employee for the Section 911 exclusion.

Therefore, the maximum housing expense amount for an individual, who qualifies for the entire year in 2007, is generally $25,710 ($85,700 X 30%) and the maximum exclusion (or deduction) for 2007 is, therefore, $11,998 ($25,710 – $13,712 <$85,700 X 16%>).

Be aware that although the general limitation applied to the housing cost amount is 30 percent of $80,000 (adjusted annually for inflation), this limit can vary, based on the country in which the individual resides. The newest adjustments to the limit, based on geographic location, are published in IRS Notice 2007-77. Among those places where the limits are higher than last year are: Singapore, Moscow and Kuala Lumpur. Hong Kong has the highest maximum housing exclusion listed in the notice ($114,300 instead of $25,710).

Foreign Housing Exclusion

When individuals do not have self-employment earnings, all of their earnings are deemed employer-provided and, therefore, all housing costs are deemed paid for with “employer-provided amounts.” So, while any housing reimbursements and/or allotments (even reimbursements for education, for example) from the employer are included, simply having a salary makes the individual eligible for the foreign housing exclusion. The exclusion is calculated on IRS Form 2555, Foreign Earned Income.

The total amount of housing costs that may be excluded from the individual’s gross income cannot exceed the individual's foreign earned income for the tax year. Also, if an individual claims the foreign housing exclusion, they cannot claim the foreign tax credit.

Foreign Housing Deduction

If none of the expatriate’s housing is paid for by an employer and the individual has self-employment income, the individual can deduct an amount paid for housing (subject to certain limitations). As with the exclusion, the amount is calculated on IRS Form 2555.

The allowable housing deduction is limited to the individual’s foreign earned income for the year less the total of:

• The amount of the individual’s foreign earned income excluded from gross income under IRS Code Section 911(a) for the year, plus
  
• The amount of the individual’shousing exclusion.

Any housing deduction not allowed a self-employed individual due to the limitation, may be carried over to the following year. This is a one-year-only carryover rule.

Miscellaneous, But Important …

• An individual may be entitled to both the foreign housing exclusion and the foreign housing deduction if they have both self-employment wages and employer-provided amounts. The housing cost amount must be prorated between the two categories.
• If a husband and wife are both qualifying individuals, they may calculate their housing cost amount either separately or jointly. (Yet another place where income tax planning software is most welcome.)
• The Tax Increase Prevention and Reconciliation Act of 2005 added a provision that requires expatriates to add back the excluded amounts of their foreign earned income and housing costs to their taxable income in order to determine the applicable rate at which they will be taxed. So, although the excluded amounts are not taxed, it can cause the taxpayer’s other income to be taxed at a higher rate. This provision is effective for tax years beginning after December 31, 2005.
• If an individual chooses to exclude a foreign housing amount, then the excluded amount must be calculated before the foreign earned income exclusion is calculated. This is because the foreign earned income exclusion is limited to the amount of the individual’s foreign earned income less any foreign housing exclusion amount.

Conclusion

The eligible housing cost amount is the individual’s total housing expenses for the year (limited to 30 percent of the maximum foreign earned income exclusion amount), less the base housing amount (16% of the maximum foreign earned income exclusion amount). The excluded amount cannot exceed either the individual's foreign earned income for the tax year or their actual housing expenses. The deducted amount also cannot exceed the individual's actual housing expenses, nor can it exceed the individual’s foreign earned income for the tax year reduced by both the individual’s excluded foreign earned income and the excluded housing amount.

The total of an individual’s excluded foreign housing costs, their deducted foreign housing costs, and their excluded foreign earned income cannot exceed their foreign earned income for the year. (Section 911(d)(7))

And, finally, since the taxpayer cannot claim the foreign tax credit if claiming the foreign housing exclusion, it has to be thoroughly thought out whether claiming the exclusions are the best approach. Good tax planning software can help with the decision making process, as well as the many calculations described in this article.

For more information, visit BNA Software.

Nancy Faussett, CPA, has over 25 years of tax accounting experience. With BNA Software since October 2001, Nancy serves as in-house expert on fixed assets, depreciation, and various areas of corporate and individual income taxation. Author of the Best Depreciation Guide for Best Software (now Sage), Nancy has also been published in Strategic Finance and the ACT Journal. Previously she was vice president of tax preparation for General Business Services and later worked as a depreciation and tax specialist for Best Software.