Make Sure You're Prepared: Changes in Foreign Income Exclusion

Q: Has the foreign earned income exclusion of $85,700 been made official by the IRS?
J.A. Shields, Bagram (Afghanistan)

A: First, J.A. thanks for the good work you are doing over there.  Second, you're correct that there has been a lot of changes to the Foreign Earned Income Exclusion, and it goes a lot deeper than just the level of the exclusion...

For those that don't know much about how the Foreign Earned Income Exclusion works, click here to read my general treatment of it.

As many overseas Americans by now know, there have been several changes made to the exclusion by the Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222), a bill which actually passed and became law in 2006.  This bill made several changes to the rules in this area:

1. The earned income exclusion level has been increased and will index to inflation going-forward.  For 2007, the exclusion level is $85,700.  In 2008 and onward, this will get higher and higher.
2. The housing exclusion, which is on top of the earned income exclusion, is now treated very differently.  The annual housing exclusion (which must be pro-rated by days spent abroad) is now limited to 30% of the earned income exclusion.  Thus, for 2007 the maximum housing exclusion is $25,710.  Some countries have even higher levels set by the Treasury Department (the most prominent being the U.K. for most Americans).  More details can be found here.
3. Here's the killer.  Any income that still remains after the exclusions have been applied--for instance, unearned income, U.S. source income of any kind, etc.--must have tax paid in the bracket that would apply if the exclusion had never been claimed.

That last one probably needs an example.  Suppose a single filer is able to exclude $100,000 of foreign earned income and housing.  After his standard deduction and personal exemption, he has taxable income from bank interest in the U.S. of $5,000.

Under the old rules, this $5,000 of taxable income would be in the 10% bracket, and he would owe $500 in tax.

Under the new rules, he pays tax as if his taxable income were $105,000.  This would put him in the 28% bracket.  Rather than owing $500 (10%) on the $5,000, he would actually owe $1,400 (28%) on the $5,000.  That's quite a difference.

This means that tax professionals are going to have to be extra careful to see whether the foreign earned income exclusion (if eligible) or the foreign tax credit makes the most sense for their clients.  There's really no good way to know for some taxpayers, so it will involve some extra work.  It's pretty evident that Congress is trying to limit the exclusion to low- and moderate-income taxpayers.  The well-off and those with substantial U.S.-source income-producing assets (or investment portfolios) will probably be better off taking the foreign tax credit.