U.S. citizens and resident aliens living outside the United States generally are allowed the same deductions as citizens and residents living in the United States.

If you choose to exclude foreign earned income or housing amounts, you cannot deduct, exclude, or claim a credit for any item that can be allocated to or charged against the excluded amounts. This includes any expenses, losses, and other normally deductible items that are allocable to the excluded income. You can deduct only those expenses connected with earning includible income.

These rules apply only to items definitely related to the excluded earned income and they do not apply to other items that are not definitely related to any particular type of gross income. These rules do not apply to items such as:

For purposes of these rules, your housing deduction is not treated as allocable to your excluded income, but the deduction for self-
employment tax is.

If you receive foreign earned income in a tax year after the year in which you earned it, you may have to file an amended return for the earlier year to properly adjust the amounts of deductions, credits, or exclusions allocable to your foreign earned income and housing exclusions.

You can claim an exemption for your nonresident alien spouse on your separate return, provided your spouse has no gross income for U.S. tax purposes and is not the dependent of another U.S. taxpayer.

You can also claim exemptions for dependents who qualify under all the dependency tests. The dependent must be a U.S. citizen or national or a resident of the United States, Canada, or Mexico for some part of the calendar year in which your tax year begins.

If you make contributions directly to a foreign church or other foreign charitable organization, you generally cannot deduct them. Exceptions are explained under Canadian, Israeli, and Mexican organizations, later.

You can deduct contributions to a U.S. organization that transfers funds to a charitable foreign organization if the U.S. organization controls the use of the funds by the foreign organization, or if the foreign organization is just an administrative arm of the U.S. organization.

If you moved to a new home in 2004 because of your job or business, you may be able to deduct the expenses of your move. Generally, to be deductible, the moving expenses must have been paid or incurred in connection with starting work at a new job location. See Publication 521, Moving Expenses, for a complete discussion of the deduction for moving expenses and information about moves within the United States.

Allocation of Moving Expenses

When your new place of work is in a foreign country, your moving expenses are directly connected with the income earned in that foreign country. If you exclude all or part of the income that you earn at the new location under the foreign earned income exclusion or the foreign housing exclusion, you cannot deduct the part of your moving expense that is allocable to the excluded income.

Also, you cannot deduct the part of the moving expense related to the excluded income for a move from a foreign country to the United States if you receive a reimbursement that you are able to treat as compensation for services performed in the foreign country.

Year to which expense is connected.   The moving expense is connected with earning the income (including reimbursements, as discussed in chapter 4 under Reimbursement of moving expenses) either entirely in the year of the move or in 2 years. It is connected with earning the income entirely in the year of the move if you qualify under the bona fide residence test or physical presence test for at least 120 days during that tax year.

  If you do not qualify under either the bona fide residence test or the physical presence test for at least 120 days during the year of the move, the expense is connected with earning the income in 2 years. The moving expense is connected with the year of the move and the following year if the move is from the United States to a foreign country. The moving expense is connected with the year of the move and the preceding year if the move is from a foreign country to the United States.

Amount allocable to excluded income.   To figure the amount of your moving expense that is allocable to your excluded foreign earned income (and not deductible), you must multiply your total moving expense deduction by a fraction. The numerator (top number) of the fraction is the total of your excluded foreign earned income and housing amounts for both years and the denominator (bottom number) of the fraction is your total foreign earned income for both years.

Example.

You are transferred by your employer on November 1, 2003, to Monaco. Your tax home is in Monaco, and you qualify as a bona fide resident of Monaco for the entire tax year 2004. In 2003, you paid $6,000 for allowable moving expenses for your move from the United States to Monaco. You were fully reimbursed (under a nonaccountable plan) for these expenses in the same year. The reimbursement is included in your income. Your only other income consists of $14,000 wages earned in 2003 after the date of your move, and $80,000 wages earned in Monaco for 2004.

Because you did not meet the bona fide residence test for at least 120 days during 2003, the year of the move, the moving expenses are for services you performed in both 2003 and the following year, 2004. Your total foreign earned income for both years is $100,000, consisting of $14,000 wages for 2003, $80,000 wages for 2004, and $6,000 moving expense reimbursement for both years.

You have no housing exclusion. The total amount you can exclude is $93,151, consisting of the $80,000 full-year exclusion for 2004 and a $13,151 part-year exclusion for 2003 ($80,000 times the fraction of 60 qualifying bona fide residence days over 365 total days in the year). To find the part of your moving expenses that is not deductible, multiply your $6,000 total expenses by the fraction $93,151 over $100,000. The result, $5,589, is your nondeductible amount.

  

You must report the full amount of the moving expense reimbursement in the year in which you received the reimbursement. In the preceding example, this year was 2003. You attribute the reimbursement to both 2003 and 2004 only to figure the amount of foreign earned income eligible for exclusion for each year.

Move between foreign countries.   If you move between foreign countries, your moving expense is allocable to income earned in the year of the move if you qualified under either the bona fide residence test or the physical presence test for a period that includes at least 120 days in the year of the move.

New place of work in U.S.   If your new place of work is in the United States, the deductible moving expenses are directly connected with the income earned in the United States. If you treat a reimbursement from your employer as foreign earned income (see the discussion in chapter 4), you must allocate deductible moving expenses to foreign earned income.

Storage expenses.   These expenses are attributable to work you do during the year in which you incur the storage expenses. You cannot deduct the amount allocable to excluded income.

Moving Expense Attributable to Foreign Earnings in 2 Years

If your moving expense deduction is attributable to your foreign earnings in 2 years (the year of the move and the following year), you should request an extension of time to file your return for the year of the move until after the end of the following year. By then, you should have all the information needed to properly figure the moving expense deduction. See Extensions under When To File and Pay in chapter 1.

If you do not request an extension, you should figure the part of the moving expense that you cannot deduct because it is allocable to the foreign earned income you are excluding. You do this by multiplying the moving expense by a fraction, the numerator (top number) of which is your excluded foreign earned income for the year of the move, and the denominator (bottom number) of which is your total foreign earned income for the year of the move. Once you know your foreign earnings and exclusion for the following year, you must either:

1. Adjust the moving expense deduction by filing an amended return for the year of the move, or

2. Recapture any additional unallowable amount as income on your return for the following year.

If, after you make the final computation, you have an additional amount of allowable moving expense deduction, you can claim this only on an amended return for the year of the move. You cannot claim it on the return for the second year.

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 2004) 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.

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 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.

• Foreign earned income exclusion.

• Foreign housing exclusion.

• Possession exclusion.

• 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.

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 37) 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.