How To Report Deductions

If you exclude foreign earned income or housing amounts, how you show your deductions on your tax return and how you figure the amount allocable to your excluded income depends on whether the expenses are used in figuring adjusted gross income (Form 1040, line 33) or are itemized deductions.

If you have deductions used in figuring adjusted gross income, enter the total amount for each of these items on the appropriate lines and schedules of Form 1040. Generally, you figure the amount of a deduction related to the excluded income by multiplying the deduction by a fraction, the numerator of which is your foreign earned income exclusion and the denominator of which is your foreign earned income. Enter the amount of the deduction(s) related to excluded income on line 42 of Form 2555.

If you have itemized deductions related to excluded income, enter on Schedule A (Form 1040) only the part not related to excluded income. You figure that amount by subtracting from the deduction the amount related to excluded income. Generally, you figure the amount that is related to the excluded income by multiplying the deduction by a fraction, the numerator of which is your foreign earned income exclusion and the denominator of which is your foreign earned income. Attach a statement to your return showing how you figured the deductible amount.

Example 1. You are a U.S. citizen employed as an accountant. Your tax home is in a foreign country for the entire tax year. You meet the physical presence test. Your foreign earned income for the year was $100,000, of which you choose to exclude $76,000. You have no housing exclusion. You had unreimbursed business expenses of $1,500 for travel and entertainment in earning your foreign income, of which $500 were for meals and entertainment. These expenses are deductible only as miscellaneous deductions on Schedule A (Form 1040). You also have $500 of miscellaneous expenses for managing investments that you enter on line 22 of Schedule A.

You must fill out Form 2106. On that form, reduce your deductible meal and entertainment expenses by 50% ($250). You must reduce the remaining $1,250 of travel and entertainment expenses by 76% ($950) because you excluded 76% ($76,000/$100,000) of your foreign earned income. You carry the remaining total of $300 to line 20 of Schedule A. Add the $300 to the $500 that you have on line 22 and enter the total ($800) on line 23.

On line 25 of Schedule A, enter $480, which is 2% of your adjusted gross income of $24,000 (line 34, Form 1040) and subtract it from the amount on line 23.

Enter $320 on line 26 of Schedule A.

Example 2. You are a U.S. citizen, have a tax home in a foreign country, and meet the physical presence test. You are self-employed and personal services produce the business income. Your gross income was $100,000, business expenses $60,000, and net income (profit) $40,000. You choose the foreign earned income exclusion and exclude $76,000 of your gross income. Since your excluded income is 76% of your total income, 76% of your business expenses are not deductible. Report your total income and expenses on Schedule C (Form 1040). On Form 2555 you will show the following:

1. Line 20a, $100,000, gross income
2. Lines 40 and 41, $76,000, foreign earned income exclusion
3. Line 42, $45,600 (76% x 60,000) business expenses attributable to the exclusion.

In this situation (Example 2), you cannot use Form 2555-EZ since you had self-employment income and business expenses.

Example 3. Assume in Example 2, that both capital and personal services combine to produce the business income. No more than 30% of your net income, or $12,000, assuming that this amount is a reasonable allowance for your services, is considered earned and can be excluded. Your exclusion of $12,000 is 12% of your gross income ($12,000/$100,000). Because you excluded 12% of your total income, $7,200, or 12% of your business expenses, are attributable to the excluded income and are not deductible.

Example 4. You are a U.S. citizen, have a tax home in a foreign country, and meet the physical presence test. You are self-employed and both capital and personal services combine to produce business income. Your gross income was $146,000, business expenses were $172,000, and your net loss was $26,000. A reasonable allowance for the services you performed for the business is $77,000. Because you incurred a net loss, the earned income limit of 30% of your net profit does not apply. The $77,000 is foreign earned income. If you choose to exclude the maximum $76,000, you exclude 52% of your gross income ($76,000/$146,000), and 52% of your business expenses ($89,440) are attributable to that income and not deductible. Show your total income and expenses on Schedule C (Form 1040). On Form 2555, exclude $76,000 and show $89,440 on line 42. Subtract line 42 from line 41, and enter the difference as a negative (in parentheses) on line 43. Because this amount is negative, enter it as a positive (no parentheses) on line 21, Form 1040, and combine it with your other income to arrive at total income on line 22 of Form 1040.

In this situation (Example 4), you would probably not want to choose the foreign earned income exclusion if this was the first year you were eligible. If you had chosen the exclusion in an earlier year, you might want to revoke the choice for this year. To do so would mean that you could not claim the exclusion again for the next 5 tax years without IRS approval. See Choosing the Exclusion, in chapter 4.

Example 5. You are a U.S. citizen, have a tax home in a foreign country, and meet the bona fide residence test. You have been performing services for clients as a partner in a firm that provides services exclusively in a foreign country. Capital investment is not material in producing the partnership's income. Under the terms of the partnership agreement, you are to receive 50% of the net profits. The partnership received gross income of $200,000 and incurred operating expenses of $80,000. Of the net profits of $120,000, you received $60,000 as your distributive share.

You choose to exclude $76,000 of your share of the gross income. Because you exclude 76% ($76,000/$100,000) of your share of the gross income, you cannot deduct $30,400, 76% of your share of the operating expenses (76% x $40,000). Report $60,000, your distributive share of the partnership net profit, on Schedule E (Form 1040). On Form 2555, exclude $76,000 and show $30,400 on line 42.

In this situation (Example 5), you would not use Form 2555-EZ since you had earned income other than salaries and wages and you had business expenses.

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