To Exclude or Not to Exclude

By Paul, April 21st, 2016

OK, so you are a US person and you live and work outside the US.  So the IRS allow you to claim a deduction for up to $100,800 of your non US earnings and also a part of your non US housing expenses on your Federal Tax Return, generous aren’t they!  It’s a no brainer?

Well actually it isn’t a no brainer. It may be the case that claiming the so called foreign earned income and housing exclusions may actually increase your US tax liability.  Additionally, they may reduce your ability to use unused non US tax credits in future.

This is counter intuitive and arises from the way the IRS determine the way you calculate the “benefit” of these exclusions.  Claiming these exclusions, you firstly calculate the tax on your income without the exclusions, then calculate the tax that is charged on just the income that is excluded.  Finally, subtract the tax on the excluded income from the tax on all the income and you have the final gross tax due (before credits).   This has the effect of allocating the lowest tax rate bands to the exclusions; any non-excluded income is then subject to tax at a higher effective tax rate.

The fact that your (non-excluded) income is actually subject to US tax at a slightly higher rate is not necessarily a problem.  If you are paying sufficient non US tax, these are creditable against your other non US income.  However, if you have US income that where the tax cannot be shielded using non US tax credits, an increase in the effective rate of US tax on this income may actually increase your actual US tax liability.

Additionally, you may wish to consider the impact on your non US (foreign) tax credits when claiming the aforementioned exclusions.  In this respect, the IRS have a concept described as the denial of double benefit – if you exclude non US earnings from US tax then you cannot use any of the foreign taxes attributable to this excluded income.  If the foreign tax rate is higher than the US tax charged on your excluded income, you will lose more foreign tax than you would have had to claim to avoid US tax on the excluded income.   The bottom line is that claiming the exclusion may reduce the amount of unused foreign tax credits you can carry forward (which is available for up to 10 years).

At this point we would stress that this is only a general note, each case should be viewed on its own merits.  If you are in a low tax jurisdiction claiming the exclusion(s) make complete sense.  Also, the US taxes certain income at a maximum rate (qualifying dividends and long term capital gains are taxed at a maximum rate of 20%) and an increase in the effective rate of tax will have little impact.  Also, if your earnings are less than the income and housing exclusions then claiming exclusions will probably make sense.  Be aware that if you waive the exclusion, having previously claimed it, you cannot claim it until 5 complete years have passed.

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