A limited amount of the foreign income tax you pay can be credited against your U.S. tax liability or deducted in figuring taxable income on your U.S. income tax return. It is usually to your advantage to claim a credit for foreign taxes rather than to deduct them. A credit reduces your U.S. tax liability, and any excess may be carried back and carried forward to other years. A deduction only reduces your taxable income and may be taken only in the current year. You must treat all foreign income taxes in the same way. You generally cannot deduct some foreign income taxes and take a credit for others.
If your tax home is in a foreign country and you meet either the bona fide residence test or the physical presence test, you can choose to exclude from gross income a limited amount of your foreign earned income. Your income must be for services performed in a foreign country during your period of foreign residence or presence, whichever applies. You cannot, however, exclude the pay you receive as an employee of the U.S. Government or its agencies. You cannot exclude pay you receive for services abroad for Armed Forces exchanges, officers' mess, exchange services, etc., operated by the U.S. Army, Navy, or Air Force.
If you claim the exclusion, you cannot claim any credits or deductions that are related to the excluded income. You cannot claim a foreign tax credit or deduction for any foreign income tax paid on the excluded income. Nor can you claim the earned income credit if you claim the exclusion. Also, for IRA purposes, the excluded income is not considered compensation and, for figuring deductible contributions when you are covered by an employer retirement plan, is included in your modified adjusted gross income.
If your tax home is in a foreign country and you qualify under either the bona fide residence test or physical presence test for the full calendar year, you can exclude your foreign income earned during the year up to the stated limit. However, if you qualify under either test for only part of the year, you must reduce the maximum based on the number of days within the tax year you qualified under one of the two tests.
If your tax home is in a foreign country and you meet either the bona fide residence test or the physical presence test, you may be able to claim an exclusion or a deduction from gross income for a housing amount paid to you. Housing amount is the excess, if any, of your allowable housing expenses for the tax year over a base amount. Allowable housing expenses are the reasonable expenses (such as rent, utilities other than telephone charges, and real and personal property insurance) paid or incurred during the tax year by you, or on your behalf, for your foreign housing and that of your spouse and dependents if they lived with you. You can include the rental value of housing provided by your employer in return for your services. You can also include the allowable housing expenses of a second foreign household for your spouse and dependents if they did not live with you because of dangerous, unhealthy, or otherwise adverse living conditions at your tax home. Housing expenses, for this purpose, do not include the cost of home purchase or other capital items, wages of domestic servants, or deductible interest and taxes.
The base amount is stated either as an annual figure, or per day. To figure your base amount if you are a calendar year taxpayer, multiply the per diem amount by the number of days in your period of foreign residence or presence, whichever applies, that are within the tax year. The maximum foreign housing exclusion can vary depending on which foreign country and city you establish you tax residency.
You may exclude your housing amount from income to the extent it is from employer-provided amounts. Employer-provided amounts are any amounts paid to or for you by your employer, including your salary, housing reimbursements, and the fair market value of pay given in the form of goods and services.
If you claim the exclusion, you cannot claim any credits or deductions related to excluded income, including a credit or deduction for any foreign income tax paid on the excluded income.