Citizens of the U.S. who live in foreign countries still have tax obligations and need to file returns in most cases. They must report all of their worldwide income, even if they do not earn any money in the U.S., unless they are not required to file a tax return for other reasons. Their tax rate, deductions, and credits will be mostly the same as if they were living in the U.S. However, citizens living abroad receive certain additional tax benefits. These can reduce or eliminate their tax burdens.
One of these benefits is known as the foreign tax credit. It allows citizens living abroad to avoid double taxation by taking a credit for income taxes or taxes on excess profits that they paid in the country where they live. The credit does not cover sales taxes, property taxes, or value-added taxes in the foreign country. The credit will apply to the amount of your U.S. income tax that arises from your foreign income. This may be calculated as the foreign income taxes that you paid or as a limitation based on an IRS formula, whichever amount is less. (You can claim an itemized deduction for foreign income taxes on Schedule A instead, but the foreign tax credit provides a greater benefit in most situations.)
Exclusions from Income
Instead of claiming the foreign tax credit, you can claim exclusions from your gross income. You must choose between the credit and the exclusions, since you cannot claim both sets of benefits. The exclusions cover foreign earned income up to a set ceiling, which increases each year, as well as foreign housing costs if they exceed 16 percent of the exclusion for foreign earned income. The exclusion for foreign housing costs cannot exceed 30 percent of the exclusion claimed for foreign earned income. The main advantage of the exclusions over the foreign tax credit is that the exclusions apply even if you are not subject to income tax in your country of residence. If you pay only a small amount of foreign taxes, the exclusions also may result in a greater benefit.
You do not need to choose between the exclusions. Since they are claimed on an individual basis, both spouses in a married couple can claim them even if they file their taxes jointly. If you are self-employed, you will need to claim a foreign housing deduction instead of the foreign housing exclusion.
You must meet certain requirements to qualify for the exclusions. Any taxpayer who qualifies for them must maintain their tax home in a foreign country and earn foreign income. In addition, they must fall into one of three categories. The first category consists of U.S. citizens who reside abroad for at least an entire tax year without interruption. The second category consists of non-citizens with legal status in the U.S. who are citizens or nationals of countries with which the U.S. has income tax treaties, and who have resided abroad for at least an entire tax year without interruption. The third and final category consists of U.S. citizens or non-citizens with legal status in the U.S. who are physically absent from the U.S. for at least 330 full days during any period of 12 consecutive months.