Prior to the Act a qualified individual was permitted to exclude a maximum of $80,000 of qualified income for any calendar year.  Additionally, they were also allowed an exclusion for certain foreign housing costs paid in excess of $12,447 with the only limitation being that the combined foreign earned income exclusion and housing cost exclusion cannot exceed the taxpayer’s total foreign earned income.  And, lastly a dollar for dollar tax credit was allowed on income that was effectively taxed in both jurisdictions if it did not qualify to be excluded. 

Enter the Tax Increase Prevention Act.  The Act amends the foreign earned income exclusion so that the $80,000 amount is adjusted for inflation starting in 2006, thus, the maximum that can be excluded in 2006 is $82,400.  The Act also amends the housing cost amount to be those qualifying expenses in excess of $13,184 with a maximum foreign housing cost exclusion of $11,536.   Additionally, the Act indicates that regular tax is equal to the excess (if any) of the regular tax that would be imposed if the taxpayer’s taxable income included the excluded income over the tax which would be imposed if the taxable income were equal to the excluded amount.  Looking at these provisions individually they seem to go from good to bad to worse. 

The maximum exclusion of $80,000 was not scheduled to be indexed for inflation until 2008.  Indexing the exclusion amount now provides for an additional possible exclusion of $2,400 as the first part of the Act allowed for the exclusion to be indexed for inflation starting in 2006. 

The Act placed a limit on the amount of the housing exclusion.  The limit is now equal to 30% of the maximum Foreign Earned Income exclusion computed on a daily basis or $11,536 annually at $31.61 per day.  The housing exclusions are now amounts in excess of $13,184 (16% of the maximum Foreign Earned Income exclusion) with an upper limit of $11,536. 

The last item that the Act changed is the method for computing tax for an expatriate.  The tax is now equal to the excess of: 

a)                    the tax computed on a taxpayer’s taxable income adding the foreign exclusions to the taxable income over

b)                    the tax computed on the amount of the foreign exclusions only.   

This change results in an increase to the taxpayer’s effective tax rate. 

Additionally, two Internal Revenue Service officials cautioned recently that the agency is stepping up its audits of U.S. taxpayers living abroad and claiming residency tax breaks and foreign tax credits.

Please contact Bill Burns at 215-564-1900 if you have any questions.

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