Contributions to Individual Retirement Arrangements

Contributions to your individual retirement arrangements (IRAs) that are traditional IRAs or Roth IRAs are generally limited to the lesser of $3,000 ($3,500 if 50 or older in 2002) or your compensation that is includible in your gross income for the tax year. Therefore, do not take into account compensation you exclude under either the foreign earned income exclusion or the foreign housing exclusion. Do not reduce your compensation by the foreign housing deduction.

If you are covered by an employer retirement plan at work, your deduction for your contributions to your traditional IRAs is generally limited based on your modified adjusted gross income. This is your adjusted gross income figured without taking into account the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction. Other modifications are also required. For more information on IRAs, see Publication 590.

Taxes of Foreign Countries and U.S. Possessions

You can take either a credit or a deduction for income taxes paid to a foreign country or a U.S. possession. Taken as a deduction, foreign income taxes reduce your taxable income. Taken as a credit, foreign income taxes reduce your tax liability. You must treat all foreign income taxes the same way. You generally cannot deduct some foreign income taxes and take a credit for others. However, regardless of whether you take a credit for foreign income taxes, you may be able to deduct other foreign taxes. See Deduction for Other Foreign Taxes, later.

There is no rule to determine whether it is to your advantage to take a deduction or a credit for foreign income taxes. In most cases, it is to your advantage to take foreign income taxes as a tax credit, which you subtract directly from your U.S. tax liability, rather than as a deduction in figuring taxable income. However, if foreign income taxes were imposed at a high rate and the proportion of foreign income to U.S. income is small, a lower final tax may result from deducting the foreign income taxes. In any event, you should figure your tax liability both ways and then use the one that is better for you.

You can make or change your choice within 10 years from the due date for filing the tax return on which you are entitled to take either the deduction or the credit.

Foreign income taxes.   These are generally income taxes you pay to any foreign country or possession of the United States.

Foreign income taxes on U.S. return.   Foreign income taxes can only be taken as a credit on Form 1040, line 45, or as an itemized deduction on Schedule A. These amounts cannot be included as withheld income taxes on Form 1040, line 62.

Foreign taxes paid on excluded income.   You cannot take a credit or deduction for foreign income taxes paid on earnings you exclude from tax under any of the following.

1. Foreign earned income exclusion.
2. Foreign housing exclusion.
3. Possession exclusion.
4. Extraterritorial income exclusion.

If your wages are completely excluded, you cannot deduct or take a credit for any of the foreign taxes paid on these wages.

If only part of your wages is excluded, you cannot deduct or take a credit for the foreign income taxes allocable to the excluded part. You find the taxes allocable to your excluded wages by applying a fraction to the foreign taxes paid on foreign earned income received during the tax year. The numerator (top number) of the fraction is your excluded foreign earned income received during the tax year minus deductible expenses allocable to that income (not including the foreign housing deduction). The denominator (bottom number) of the fraction is your total foreign earned income received during the tax year minus all deductible expenses allocable to that income (including the foreign housing deduction).

If foreign law taxes both earned income and some other type of income and the taxes on the other type cannot be separated, the denominator of the fraction is the total amount of income subject to foreign tax minus deductible expenses allocable to that other type of income.

If you take a foreign tax credit for tax on income you could have excluded under your choice to exclude foreign earned income or your choice to exclude foreign housing costs, one or both of the choices may be considered revoked.

Credit for Foreign Income Taxes

If you take the foreign tax credit, you may have to file Form 1116 with Form 1040. Form 1116 is used to figure the amount of foreign tax paid or accrued that can be claimed as a foreign tax credit. Do not include the amount of foreign tax paid or accrued as withheld federal income taxes on Form 1040, line 62.

The foreign income tax for which you can claim a credit is the amount of legal and actual tax liability you pay or accrue during the year. The amount for which you can claim a credit is not necessarily the amount withheld by the foreign country. You cannot take a foreign tax credit for income tax you paid to a foreign country that would be refunded by the foreign country if you made a claim for refund.

Subsidies.   If a foreign country returns your foreign tax payments to you in the form of a subsidy, you cannot claim a foreign tax credit based on these payments. This rule applies to a subsidy provided by any means that is determined, directly or indirectly, by reference to the amount of tax, or to the base used to figure the tax.

Some ways of providing a subsidy are refunds, credits, deductions, payments, or discharges of obligations. A credit is also not allowed if the subsidy is given to a person related to you, or persons who participated in a transaction or a related transaction with you.

Limit

The foreign tax credit is limited to the part of your total U.S. tax that is in proportion to your taxable income from sources outside the United States compared to your total taxable income. The allowable foreign tax credit cannot be more than your actual foreign tax liability.

Exemption from limit.   You will not be subject to this limit and will not have to file Form 1116 if you meet all three of the following requirements.

1. Your only foreign source income for the year is passive income (dividends, interest, royalties, etc.) that is reported to you on a payee statement (such as a Form 1099-DIV or 1099-INT).
2. Your foreign taxes for the year that qualify for the credit are not more than $300 ($600 if you are filing a joint return) and are reported on a payee statement.
3. You elect this procedure.

If you make this election, you cannot carry back or carry over any unused foreign tax to or from this year.

Separate limit.   You must figure the limit on a separate basis with regard to each of the following categories of foreign source income (see the instructions for Form 1116).

• Passive income.
• High withholding tax interest.
• Financial services income.
• Shipping income.
• Certain dividends from a domestic international sales corporation (DISC) or former DISC.
• Certain distributions from a foreign sales corporation (FSC) or former FSC.
• Any lump-sum distributions from employer benefit plans for which a special averaging treatment is used to determine your tax.
• Section 901(j) income.
• Certain income re-sourced by treaty.
• All other income not included above (general limitation income).

Figuring the limit.   In figuring taxable income in each category, you take into account only the amount that you must include in income on your federal tax return. Do not take any excluded amount into account.

To determine your taxable income in each category, deduct expenses and losses that are definitely related to that income.

Other expenses (such as itemized deductions or the standard deduction) not definitely related to specific items of income must be apportioned to the foreign income in each category by multiplying them by a fraction. The numerator (top number) of the fraction is your gross foreign income in the separate limit category. The denominator (bottom number) of the fraction is your gross income from all sources. For this purpose, gross income includes amounts that are otherwise exempt or excluded. You must use special rules for deducting interest expenses. For more information on allocating and apportioning your deductions, see Publication 514.

Exemptions.   Do not take the deduction for exemptions for yourself, your spouse, or your dependents in figuring taxable income for purposes of the limit.

Recapture of foreign losses.   If you have an overall foreign loss and the loss reduces your U.S. source income (resulting in a reduction of your U.S. tax liability), you must recapture the loss in later years when you have taxable income from foreign sources. This is done by treating a part of your taxable income from foreign sources in later years as U.S. source income. This reduces the numerator of the limiting fraction and the resulting foreign tax credit limit.

Foreign tax credit carryback and carryover.   The amount of foreign income tax not allowed as a credit because of the limit can be carried back 2 years and carried forward 5 years.

More information on figuring the foreign tax credit can be found in Publication 514.

Deduction for Foreign Income Taxes

Instead of taking the foreign tax credit, you can deduct foreign income taxes as an itemized deduction on Schedule A (Form 1040).

You can deduct only foreign income taxes paid on income that is subject to U.S. tax. You cannot deduct foreign taxes paid on earnings you exclude from tax under any of the following.

1. Foreign earned income exclusion.
2. Foreign housing exclusion.
3. Possession exclusion.
4. Extraterritorial income exclusion.

Example.   You are a U.S. citizen and qualify to exclude your foreign earned income. Your excluded wages in Country X are $70,000 on which you paid income tax of $10,000. You received dividends from Country X of $2,000 on which you paid income tax of $600.

You can deduct the $600 tax payment because the dividends relating to it are subject to U.S. tax. Because you exclude your wages, you cannot deduct the income tax of $10,000.

If you exclude only a part of your wages, see the earlier discussion under Foreign taxes paid on excluded income.

Deduction for Other Foreign Taxes

You can deduct real property taxes you pay that are imposed on you by a foreign country. You take this deduction on Schedule A (Form 1040). You cannot deduct other foreign taxes, such as personal property taxes, unless you incurred the expenses in a trade or business or in the production of income.

On the other hand, you generally can deduct personal property taxes when you pay them to U.S. possessions. But if you claim the possession exclusion, see Publication 570.

The deduction for foreign taxes other than foreign income taxes is not related to the foreign tax credit. You can take deductions for these miscellaneous foreign taxes and also claim the foreign tax credit for income taxes imposed by a foreign country.

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 36) 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 total deduction the amount related to excluded income. Generally, you figure the amount that is related to the excluded income by multiplying the total 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 Germany for the entire tax year. You meet the physical presence test. Your foreign earned income for the year was $100,000 and your investment income was $12,000. After excluding $80,000, your AGI is $32,000.

You had unreimbursed business expenses of $1,500 for travel and entertainment in earning your foreign income, of which $500 was for meals and entertainment. These expenses are deductible only as miscellaneous deductions on Schedule A (Form 1040). You also have $500 of miscellaneous expenses that is not related to your foreign income 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 80% ($1,000) because you excluded 80% ($80,000/$100,000) of your foreign earned income. You carry the remaining total of $250 to line 20 of Schedule A. Add the $250 to the $500 that you have on line 22 and enter the total ($750) on line 23.

On line 25 of Schedule A, enter $640, which is 2% of your adjusted gross income of $32,000 (line 36, Form 1040) and subtract it from the amount on line 23.

Enter $110 on line 26 of Schedule A.

Example 2.   You are a U.S. citizen, have a tax home in France, 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 $80,000 of your gross income. Since your excluded income is 80% of your total income, 80% 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, $80,000, foreign earned income exclusion
3. Line 42, $48,000 (80% × $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, is attributable to the excluded income and is not deductible.

Example 4.   You are a U.S. citizen, have a tax home in Brazil, 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 $77,000, you exclude 52.74% of your gross income ($77,000 ÷ $146,000), and 52.74% of your business expenses ($90,713) is attributable to that income and not deductible. Show your total income and expenses on Schedule C (Form 1040). On Form 2555, exclude $77,000 and show $90,713 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 Venezuela, 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 Venezuela. 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 $80,000 of your share of the gross income. Because you exclude 80% ($80,000 ÷ $100,000) of your share of the gross income, you cannot deduct $32,000, 80% of your share of the operating expenses (80% × $40,000). Report $60,000, your distributive share of the partnership net profit, on Schedule E (Form 1040), Supplemental Income and Loss. On Form 2555, show $80,000 on line 40 and show $32,000 on line 42. Your exclusion on Form 2555 is $48,000.

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

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