5.   Exemptions, Deductions, and Credits

Topics - This chapter discusses:

  • The rules concerning items related to excluded income,

  • Exemptions,

  • Contributions to foreign charitable organizations,

  • Moving expenses,

  • Contributions to individual retirement arrangements (IRAs),

  • Taxes of foreign countries and U.S. possessions, and

  • How to report deductions.

Useful Items - You may want to see:

Publication

  • 501 Exemptions, Standard Deduction, and Filing Information

  • 514 Foreign Tax Credit for Individuals

  • 521 Moving Expenses

  • 523 Selling Your Home

  • 590 Individual Retirement Arrangements (IRAs)

  • 597 Information on the United States—Canada Income Tax Treaty

Form (and Instructions)

  • 1116 Foreign Tax Credit

  • 2106 Employee Business Expenses

  • 2555 Foreign Earned Income

  • 2555-EZ Foreign Earned Income Exclusion

  • 3903 Moving Expenses

  • Schedule A (Form 1040) Itemized Deductions

  • Schedule C (Form 1040) Profit or Loss From Business

  • SS-5 Application for a Social Security Card

  • W-7 Application for IRS Individual Taxpayer Identification Number

See chapter 7 for information about getting these publications and forms.

Items Related to Excluded Income

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:

  • Personal exemptions,

  • Qualified retirement contributions,

  • Alimony payments,

  • Charitable contributions,

  • Medical expenses,

  • Mortgage interest, or

  • Real estate taxes on your personal residence.

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.

Example.

In 2012, you had $90,400 of foreign earned income and $9,500 of deductions allocable to your foreign earned income. You did not have a housing exclusion. Because you excluded all of your foreign earned income, you would not have been able to claim any of the deductions on your 2012 return.

In 2013, you received a $12,000 bonus for work you did abroad in 2012. You can exclude $4,700 of the bonus because the limit on the foreign earned income exclusion for 2012 was $95,100 and you have already excluded $90,400. Since you must include $7,300 of the bonus ($12,000 − $4,700) for work you did in 2012 in income, you can file an amended return for 2012 to claim $677 of the deductions. This is the deductions allocable to the foreign earned income ($9,500) multiplied by the includible portion of the foreign earned income ($7,300) and divided by the total foreign earned income for 2012 ($102,400).

Exemptions

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 also can claim exemptions for individuals who qualify as your dependents. To be your dependent, the individual must be a U.S. citizen, U.S. national, U.S. resident alien, or a resident of Canada or Mexico for some part of the calendar year in which your tax year begins.

Children.   Children usually are citizens or residents of the same country as their parents. If you were a U.S. citizen when your child was born, your child generally is a U.S. citizen. This is true even if the child's other parent is a nonresident alien, the child was born in a foreign country, and the child lives abroad with the other parent.

  If you have a legally adopted child who is not a U.S. citizen, U.S. resident, or U.S. national, the child meets the citizen requirement if you are a U.S. citizen or U.S. national and the child lived with you as a member of your household all year.

Social security number.   You must include on your return the social security number (SSN) of each dependent for whom you claim an exemption. To get a social security number for a dependent, apply at a Social Security office or U.S. consulate. You must provide original or certified copies of documents to verify the dependent's age, identity, and citizenship, and complete Form SS-5.

  If you do not have an SSN for a child who was born in 2013 and died in 2013, attach a copy of the child's birth certificate to your tax return. Print “Died” in column (2) of line 6c of your Form 1040 or Form 1040A.

  If your dependent is a nonresident alien who is not eligible to get a social security number, you must list the dependent's individual taxpayer identification number (ITIN) instead of an SSN. To apply for an ITIN, file Form W-7 with the IRS. It usually takes 6 to 10 weeks to get an ITIN. Enter your dependent's ITIN wherever an SSN is requested on your tax return.

More information.   For more information about exemptions, see Publication 501.

Contributions to Foreign Charitable Organizations

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

Canadian, Mexican, and Israeli charities.   Under the income tax treaties with Canada, Mexico and Israel, you may be able to deduct contributions to certain Canadian, Mexican, and Israeli charitable organizations. Generally, you must have income from sources in Canada, Mexico, or Israel, and the organization must meet certain requirements. See Publication 597, Information on the United States-Canada Income Tax Treaty, and Publication 526, Charitable Contributions, for more information.

Moving Expenses

If you moved to a new home in 2013 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 for a complete discussion of the deduction for moving expenses and information about moves within the United States.

Foreign moves.   A foreign move is a move in connection with the start of work at a new job location outside the United States and its possessions. A foreign move does not include a move back to the United States or its possessions.

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 for the foreign earned income exclusion 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.

On November 1, 2012, you transfer to Monaco. Your tax home is in Monaco, and you are a bona fide resident of Monaco for the entire tax year 2013. In 2012, 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 $16,000 wages earned in 2012 after the date of your move, and $100,100 wages earned in Monaco for 2013.

Because you did not meet the bona fide residence test for at least 120 days during 2012, the year of the move, the moving expenses are for services you performed in both 2012 and the following year, 2013. Your total foreign earned income for both years is $122,100, consisting of $16,000 wages for 2012, $100,100 wages for 2013, and $6,000 moving expense reimbursement for both years.

You have no housing exclusion. The total amount you can exclude is $113,190, consisting of the $97,600 full-year exclusion for 2013 and a $15,590 part-year exclusion for 2012 ($95,100 times the fraction of 60 qualifying bona fide residence days over 366 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 $113,190 over $122,100. The result, $5,562, 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 2012. You attribute the reimbursement to both 2012 and 2013 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 second 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:

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

  • 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.

Forms To File

Report your moving expenses on Form 3903. Report your moving expense deduction on line 26 of Form 1040. If you must reduce your moving expenses by the amount allocable to excluded income (as explained later under How To Report Deductions ), attach a statement to your return showing how you figured this amount.

For more information about figuring moving expenses, see Publication 521.

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 $5,500 ($6,500 if 50 or older) or your compensation that is includible in your gross income for the tax year. In determining compensation for this purpose, do not take into account amounts 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. If you take a credit for any foreign income taxes, you cannot deduct any foreign income taxes. However, 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 47, 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.
  • Foreign earned income exclusion.

  • Foreign housing exclusion.

  • Possession exclusion.

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

  • 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.

  • 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 “passive category income” and “general category income” (see the instructions for Form 1116).

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 income that is excluded under the foreign earned income provisions but does not include any other exempt income. 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.

Recapture of domestic losses.   If you have an overall domestic loss (resulting in no U.S. tax liability), you cannot claim a foreign tax credit for taxes paid during that year. You must recapture the loss in later years when you have U.S. source taxable income. This is done by treating a part of your taxable income from U.S. sources in later years as foreign source income. This increases 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 1 year and carried forward 10 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.

  • Foreign earned income exclusion.

  • Foreign housing exclusion.

  • Possession 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 38) 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 44 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 $122,000 and your investment income was $10,380. After excluding $97,600, your AGI is $34,780.

You had unreimbursed business expenses of $2,500 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 are not related to your foreign income that you enter on line 23 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 $2,250 of travel and entertainment expenses by 80% ($1,800) because you excluded 80% ($97,600/$122,000) of your foreign earned income. You carry the remaining total of $450 to line 21 of Schedule A. Add the $450 to the $500 that you have on line 23 and enter the total ($950) on line 24.

On line 26 of Schedule A, enter $696, which is 2% of your adjusted gross income of $34,780 (line 38, Form 1040) and subtract it from the amount on line 24.

Enter $254 on line 27 of Schedule A.

Example 2.

You are a U.S. citizen, have a tax home in Spain, and meet the physical presence test. You are self-employed and personal services produce the business income. Your gross income was $116,931, business expenses $66,895, and net income (profit) $50,036. You choose the foreign earned income exclusion and exclude $97,600 of your gross income. Since your excluded income is 83.47% of your total income, 83.47% 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:

  • Line 20a, $116,931, gross income,

  • Lines 42 and 43, $97,600, foreign earned income exclusion, and

  • Line 44, $55,837 (83.47% × $66,895) 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 $15,011, assuming that this amount is a reasonable allowance for your services, is considered earned and can be excluded. Your exclusion of $15,011 is 12.84% of your gross income ($15,011 ÷ $116,931). Because you excluded 12.84% of your total income, $8,589 (.1284 x $66,895) 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 is 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 44. Subtract line 44 from line 43, and enter the difference as a negative (in parentheses) on line 45. 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 Panama, 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 Panama. 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 $244,000 and incurred operating expenses of $98,250. Of the net profits of $145,750, you received $72,875 as your distributive share.

You choose to exclude $97,600 of your share of the gross income. Because you exclude 80% ($97,600 ÷ $122,000) of your share of the gross income, you cannot deduct $39,300, 80% of your share of the operating expenses (.80 × $49,125). Report $72,875, your distributive share of the partnership net profit, on Schedule E (Form 1040), Supplemental Income and Loss. On Form 2555, show $97,600 on line 42 and show $39,300 on line 44. Your exclusion on Form 2555 is $58,300.

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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