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When you work abroad as a contractor, you are generally subject to the tax jurisdiction of the foreign country in which you work, even if your paycheck comes from a U.S. client. In principle, you are also subject to U.S. tax jurisdiction if you are a U.S. citizen or lawful permanent resident. To avoid double taxation, however, the Internal Revenue Code offers significant tax benefits to expatriates.
You must spend sufficient time abroad during the tax year to take the foreign earned income exclusion or the foreign housing deduction. You must pass either the bona fide residence test or the physical presence test. You pass the bona fide residence test if you lived as a legal resident in the same foreign country for the entire year. You pass the physical presence test if you were physically present in a foreign country or countries for 330 days or more in any 12-month period, as long as that 12-month period includes any portion of the tax year. Independent contractors who move from country to country during the tax year should seek to qualify under the physical presence test.
Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion is an amount that you subtract from your taxable income before you are taxed on it. At publication date, it is worth $95,100 if you spent the entire year abroad. If you spent less than the entire year abroad, you must reduce this amount in proportion to the time you spent abroad. For example, if you spent 90 percent of the year abroad, you must reduce your foreign-earned income exclusion by 10 percent.
Foreign Housing Deduction
While the Foreign Housing Exclusion is available to employees who work overseas, the Foreign Housing Deduction is available to independent contractors. The Foreign Housing Deduction is designed to give you a tax break for housing expenses that exceed what you would pay in the U.S, and is equal to 16 percent of your Foreign Earned Income Exclusion. It covers all reasonable housing expenses including rent, utilities and homeowner's insurance. Although the IRS allows you a limited ability to use both the Foreign Earned Income Exclusion and the Foreign Housing Deduction, you can't simply add them together.
Alternative: The Foreign Tax Credit
You might qualify for the Foreign Tax Credit based on taxes paid to a foreign government. This credit allows you to subtract foreign taxes actually paid from your U.S. tax liability. There is no income limit on the foreign tax credit -- you can use it to avoid all of your U.S. income taxes no matter how much money you make, as long as you paid enough in foreign taxes to offset your U.S. tax liability. If the foreign tax rate is equal to or higher than your U.S. tax rate, you will have zero federal income tax liability. However, you can't credit any excess foreign taxes paid against future U.S. taxes owed
- Escape From America Magazine: US Tax Facts for Americans Living and Working Abroad
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- Internal Revenue Service: Tax Guide for U.S. Citizens and Resident Aliens Abroad
- Internal Revenue Service: Foreign Housing Exclusion or Deduction [
- Internal Revenue Service: Foreign Earned Income Exclusion
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