Publication 54
Tax Guide for U.S. Citizens and Resident Aliens Abroad

For use in preparing 2002 Returns

Meeting the Requirements
of Either the Bona Fide
Residence Test or the
Physical Presence Test

1) I recently came to Country X to work for the Orange Tractor Co. and I expect to be here for 5 or 6 years. I understand that upon the completion of 1 full year I will qualify under the bona fide residence test. Is this correct?

Not necessarily. The law provides that to qualify under this test for the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, a person must be a bona fide resident of a foreign country or countries for an uninterrupted period which includes an entire taxable year.

If, like most U.S. citizens, you file your return on a calendar year basis, the taxable year referred to in the law would be from January 1 to December 31 of any particular year. Unless you established residence in Country X on January 1, it would be more than 1 year before you could qualify as a bona fide resident of a foreign country. Once you have completed your qualifying period, however, you are entitled to exclude the income or to claim the housing exclusion or deduction from the date you established bona fide residence.

2) I understand the physical presence test to be simply a matter of being physically present in a foreign country for at least 330 days within 12 consecutive months; but what are the criteria of the bona fide residence test?

To be a bona fide resident of a foreign country, you must show that you entered a foreign country intending to remain there for an indefinite or prolonged period and, to that end, you are making your home in that country. Consideration is given to the type of quarters occupied, whether your family went with you, the type of visa, the employment agreement, and any other factor pertinent to show whether your stay in the foreign country is indefinite or prolonged.

To claim the foreign earned income exclusion or foreign housing exclusion or deduction under this test, the period of foreign residence must include 1 full tax year (usually January 1 - December 31), but once you meet this time requirement, you figure the exclusions and the deduction from the date the residence actually began.

3) To meet the qualification of an uninterrupted period which includes an entire taxable year, do I have to be physically present in a foreign country for the entire year?

No. Uninterrupted refers to the bona fide residence proper and not to the physical presence of the individual. During the period of bona fide residence in a foreign country, even during the first full year, you can leave the country for brief and temporary trips back to the United States or elsewhere for vacation, or even for business. To preserve your status as a bona fide resident of a foreign country, you must have a clear intention of returning from those trips, without unreasonable delay, to your foreign residence.

4) I am a U.S. citizen and during 2001 was a bona fide resident of Country X. On January 15, 2002, I was notified that I was to be assigned to Country Y. I was recalled to New York for 90 days orientation and then went to Country Y, where I have been since. Although I was not in Country Y on January 1, I was a bona fide resident of Country X and was in Country Y on December 31, 2002. My family remained in Country X until completion of the orientation period, and my household goods were shipped directly to my new post. Can I qualify as a bona fide resident of a foreign country for 2002, or must I wait for the entire year of 2003 to qualify?

Since you did not break your period of foreign residence, you would continue to qualify as a bona fide resident for 2002.

5) Due to illness, I returned to the United States before I completed my qualifying period to claim the foreign earned income exclusion. Can I figure the exclusion for the period I resided abroad?

No. You are not entitled to any exclusion of foreign earned income since you did not complete your qualifying period under either the bona fide residence test or physical presence test. If you paid foreign tax on the income earned abroad, you may be able to claim that tax as a deduction or as a credit against your U.S. tax.

6) Can a resident alien of the United States qualify for an exclusion or deduction under the bona fide residence test or the physical presence test?

Resident aliens of the United States can qualify for the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction if they meet the requirements of the physical presence test. Resident aliens who are citizens or nationals of a country with which the United States has an income tax treaty in effect can also qualify under the bona fide residence test.

7) On August 13 of last year I left the United States and arrived in Country Z to work for the Gordon Manufacturing Company. I expected to be able to exclude my foreign earned income under the physical presence test because I planned to be in Country Z for at least 1 year. However, I was reassigned back to the United States and left Country Z on July 1 of this year. Can I exclude any of my foreign earned income?

No. You cannot exclude any of the income you earned in Country Z because you were not in a foreign country for at least 330 full days as required under the physical presence test.

Foreign Earned Income

1) I am an employee of the U.S. Government working abroad. Can all or part of my government income earned abroad qualify for the foreign earned income exclusion?

No. The foreign earned income exclusion applies to your foreign earned income. Amounts paid by the United States or its agencies to their employees are not treated, for this purpose, as foreign earned income.

2) I qualify under the bona fide residence test. Does my foreign earned income include my U.S. dividends and the interest I receive on a foreign bank account?

No. The only income that is foreign earned income is income from the performance of personal services abroad. Investment income is not earned income. However, you must include it in gross income reported on your Form 1040.

3) My company pays my foreign income tax on my foreign earnings. Is this taxable compensation?

Yes. The amount is compensation for services performed. The tax paid by your company should be reported on line 7 of Form 1040 and in item 22(f) of Part IV, Form 2555 (or line 17 of Part IV, Form 2555-EZ).

4) I live in an apartment in a foreign city for which my employer pays the rent. Should I include in my income the cost to my employer ($1,200 a month) or the fair market value of equivalent housing in the United States ($800 a month)?

No. You must include in income the fair market value (FMV) of the facility provided, where it is provided. This will usually be the rent your employer pays. Situations when the FMV is not included in income are discussed in chapter 4 under Exclusion of Meals and Lodging.

5) My U.S. employer pays my salary into my U.S. bank account. Is this income considered earned in the United States or is it considered foreign earned income?

If you performed the services to earn this salary outside the United States, your salary is considered earned abroad. It does not matter that you are paid by a U.S. employer or that your salary is deposited in a U.S. bank account in the United States. The source of salary, wages, commissions, and other personal service income is the place where you perform the services.

6) What is considered a foreign country?

For the purposes of the foreign earned income exclusion and the foreign housing exclusion or deduction, any territory under the sovereignty of a country other than the United States is a foreign country. Possessions of the United States are not treated as foreign countries.

7) What is meant by the source of earned income?

The word source refers to the place where the work or personal services that produce earned income are performed. In other words, income received for work in a foreign country has its source in that country. The foreign earned income exclusion and the foreign housing exclusion or deduction are limited to earned income from sources within foreign countries.

Foreign Earned
Income Exclusion

1) I qualify for the foreign earned income exclusion and earned more than $80,000 during the year. Am I entitled to the maximum $80,000 exclusion?

Not necessarily. Although you qualify for the foreign earned income exclusion, you may not have met either the bona fide residence test or the physical presence test for your entire tax year. If you did not meet either of these tests for your entire tax year, you must prorate the $80,000 maximum exclusion based on the number of days that you did meet either test during the year.

2) How do I qualify for the foreign earned income exclusion?

To be eligible, you must have a tax home in a foreign country and be a U.S. citizen or resident alien. You must be either a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year, or you must be physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months. U.S. citizens may qualify under either test. The physical presence test applies to all resident aliens, while the bona fide residence test applies to resident aliens who are citizens or nationals of a country with which the United States has an income tax treaty in effect.

Your tax home must be in the foreign country or countries throughout your period of residence or presence. For this purpose, your period of physical presence is the 330 full days during which you are present in a foreign country, not the 12 consecutive months during which those days occur.

3) Is it true that my foreign earned income exclusion cannot exceed my foreign earned income?

Yes. The amount of the exclusion is limited each year to the amount of your foreign earned income after reducing that income by the foreign housing exclusion. The foreign earned income must be earned during the part of the tax year that you have your tax home abroad and meet either the bona fide residence test or the physical presence test.

4) My wife and I are both employed, reside together, and file a joint return. We meet the qualifications for claiming the foreign earned income exclusion. Do we each figure a separate foreign earned income exclusion and foreign housing exclusion?

You figure your foreign earned income exclusion separately since you both have foreign earned income. The amount of the exclusion for each of you cannot exceed your separate foreign earned incomes.

If you each have a housing amount, you can figure your housing exclusion either separately or jointly. See the discussion, Married Couples Living Apart, in chapter 4 for further details.

Exemptions and
Dependency Allowances

1) I am a U.S. citizen married to a nonresident alien who has no income from U.S. sources. Can I claim an exemption for my spouse on my U.S. tax return?

Yes. You can claim an exemption for your nonresident alien spouse on your tax return if your spouse has no income from sources within the United States and is not the dependent of another U.S. taxpayer.

You must use the married filing separately column in the Tax Table or the Tax Rate Schedule for married individuals filing a separate return, unless you qualify as a head of household. (Also see Question 12 under General Tax Questions, later.)

A U.S. citizen or resident married to a nonresident alien also can choose to treat the nonresident alien as a U.S. resident for all federal income tax purposes. This allows you to file a joint return, but also subjects the alien's worldwide income to U.S. income tax.

2) What exemptions can be claimed by a U.S. citizen for a nonresident alien spouse who was blind and 65 years of age? The spouse did not have income from U.S. sources and was not a dependent of another U.S. taxpayer.

A U.S. taxpayer can generally claim one exemption for his or her spouse. In addition, if the U.S. taxpayer does not itemize deductions on Schedule A (Form 1040), the taxpayer may be entitled to a higher standard deduction if his or her spouse is age 65 or older or is blind at the end of the year.

3) I spend $375 a month to support my parents who live in Italy. I am sure this provides the bulk of their support. Can I claim exemptions for them?

It depends on whether they are U.S. citizens or residents. If your parents are not U.S. citizens or residents, you cannot claim exemptions for them even if you provide most of their support. To qualify as a dependent, a person generally must be either a citizen or national of the United States or a resident of the United States, Canada, or Mexico for some part of the tax year. The other tests of dependency also must be met.

4) Should I prorate my own personal exemption and the exemptions for my spouse and dependents, since I expect to exclude part of my income?

No. Do not prorate exemptions for yourself, your spouse, and your dependents. Claim the full amount for each exemption permitted.

Social Security and
Railroad Retirement Benefits

1) Are U.S. social security benefits taxable?

Benefits received by U.S. citizens and resident aliens may be taxable, depending on the total amount of income and the filing status of the taxpayer. Under certain treaties, U.S. social security benefits are exempt from U.S. tax if taxed by the country of residence.

Benefits similar to social security received from other countries by U.S. citizens or residents may be taxable. (Refer to our tax treaties with various countries for any benefit granted by the treaty.)

2) As a U.S. citizen or resident, how do I figure the amount of my U.S. social security benefits to include in gross income?

See Publication 915, Social Security and Equivalent Railroad Retirement Benefits, to figure if any of your benefits are includible in income.

3) How are railroad retirement benefits taxed?

The part of a tier 1 railroad retirement benefit that is equivalent to the social security benefit you would have been entitled to receive if the railroad employee's work had been covered under the social security system rather than the railroad retirement system is treated the same as a social security benefit, discussed above.

The other part of a tier 1 benefit that is not considered a social security equivalent benefit is treated like a private pension or annuity, as are tier 2 railroad retirement benefits. Pensions and annuities are explained in chapter 4 under Earned and Unearned Income. Vested dual benefits and supplemental annuities are also treated like private pensions, but are fully taxable.

The proper amounts of the social security equivalent part of tier 1 benefits and any special guaranty benefits are shown on the Form RRB-1099, Payments by the Railroad Retirement Board, that you receive from the Railroad Retirement Board. The taxable amounts of the non-social security equivalent part of tier 1, tier 2, vested dual benefits, and supplemental annuities are shown on the Form RRB-1099-R, Annuities or Pensions by the Railroad Retirement Board, that you receive from the Railroad Retirement Board.

Social Security Tax
and Self-Employment Tax

1) I am a minister with earned income from abroad and expect to qualify for the foreign earned income exclusion. How do I pay my self-employment tax?

File a Form 1040 with Schedule SE and Form 2555. Figure your self-employment tax on Schedule SE and enter it on Form 1040 as the tax due with the return.

2) Because I expect to qualify for the foreign earned income exclusion, I have requested and received an extension of time until January 30, 2004, to file my 2002 return. However, since I will be paying self-employment tax on my spouse's income, should I file a 2002 return when due, pay the self-employment tax, and then file another return when I qualify for the exclusion?

No. You do not need to file a 2002 Form 1040 (the regular income tax return) when due if you have received an extension. To stop interest from accruing on the self-employment tax due for 2002, you can pay enough estimated tax to cover the self-employment tax and any income tax that would be due after taking out the amount of excludable income.

Income Tax Withholding

1) How can I get my employer to stop withholding federal income taxes from wages while I am overseas and eligible for the foreign earned income exclusion?

File a statement in duplicate with your employer stating that withholding should be reduced because you meet the bona fide residence test or physical presence test. See also the following question.

2) Does the Internal Revenue Service provide forms to be used by employees requesting employers to stop withholding income tax from wages they expect to be excluded as income earned abroad?

Yes. Form 673 is a sample statement that can be used by individuals who expect to qualify under the bona fide residence test or the physical presence test. A copy of this form is displayed in chapter 2. You can get this form on the Internet at www.irs.gov or by writing to the Internal Revenue Service, International Section, P.O. Box 920, Bensalem, PA 19020-8518.

3) I am a U.S. citizen residing overseas, and I receive dividend and interest income from U.S. sources from which tax is being withheld at a rate of 30%. How can I have this situation corrected?

File Form W-9 (indicating that you are a U.S. citizen) with the withholding agents who are paying you the dividends and interest. This is their authority to stop withholding the 30% income tax at the source on payments due you.

4) As a U.S. citizen receiving dividend and interest income from the United States from which tax has been withheld, do I report the net dividend and interest income on my return, or do I report the gross amount and take credit for the tax withheld?

You must report the gross amount of the income received and take a tax credit for the tax withheld. This is to your advantage since the tax withheld is deducted in full from the tax due. It is also advisable to attach a statement to your return explaining this tax credit so there will be no question as to the amount of credit allowable.

Deductions

1) Can I claim a foreign tax credit even though I do not itemize deductions?

Yes. You can claim the foreign tax credit even though you do not itemize deductions.

2) I had to pay customs duty on a few things I brought back with me from Europe last summer. Can I include customs fees with my other deductible taxes?

No. Customs duties, like federal excise taxes, are not deductible.

3) Some taxes paid in the United States are not deductible if I itemize my deductions. Which ones are they?

Sales taxes, as well as the state and local taxes levied specifically on cigarettes, tobacco, and alcoholic beverages, are not deductible. In addition, no deduction can be taken for drivers' licenses or gasoline taxes. Auto registration fees cannot be deducted except when they qualify as personal property taxes. To qualify as personal property taxes they must be based on the value of the auto.

Some state and local taxes are deductible, such as those on personal property, real estate, and income.

4) What types of foreign taxes are deductible?

Generally, real estate and foreign income taxes are deductible as itemized deductions. Foreign income taxes are deductible only if you do not claim the foreign tax credit. Foreign income taxes paid on excluded income are not deductible as an itemized deduction.

Note. Foreign income taxes are usually claimed under the credit provisions, if they apply, because this is more advantageous in most cases.

5) I rented an apartment in the United Kingdom and had to pay a local tax called a general rates tax, which is based on occupancy of the apartment. Can I deduct this tax as a foreign real estate tax?

No. This tax does not qualify as a real estate tax since it is levied on the occupant of the premises rather than on the owner of the property.

Scholarship and Fellowship Grantees

1) I am a Fulbright grantee. What documentation must I attach to my return?

  a)There are no special tax forms for Fulbright grantees. File on a regular Form 1040.

b) If you claim exemption as a scholarship or fellowship grantee, submit brochures and correspondence describing the grant and your duties.

c) If you are located in a foreign country and wish to pay tax in foreign currency, you should submit a certified statement showing that you were a Fulbright grantee and at least 70% of the grant was paid in nonconvertible foreign currency (see Publication 520).

2) I taught and lectured abroad under taxable grants. What expenses can I deduct?

You may be able to deduct your travel, meals, and lodging expenses if you are temporarily absent from your regular place of employment. For more information about deducting travel, meals, and lodging expenses, get Publication 463, Travel, Entertainment, Gift, and Car Expenses.

General Tax Questions

1) Will the Internal Revenue Service representatives at the Embassies answer questions about tax laws of our home state and the laws of the foreign country where we reside as well as U.S. federal income tax laws?

No. The IRS representatives are authorized only to answer tax questions on U.S. federal income tax. You should write your home state's tax office for state tax information and contact the tax officials of the country where you reside for information regarding their taxes.

2) Can Internal Revenue Service personnel recommend tax practitioners who prepare returns?

No. IRS employees are not permitted to recommend tax practitioners who prepare income tax returns.

3) I just filed my return. How long will it take to get my refund?

It may take up to 10 weeks to issue a refund on a return that is properly made out. A refund may take longer than that if the return is filed just before the filing deadline.

An error on the return will also delay the refund. Among the most common causes of delay in receiving refunds are unsigned returns and incorrect social security numbers.

4) I have not received my refund from last year's return. Can I claim the credit against this year's tax?

No. That would cause problems to both years' returns. If your last year's refund is overdue, contact the IRS and ask about the status of the refund. If you are outside the United States, call or write the nearest IRS office. (See Services Available Outside the United States, earlier in this chapter, for a list of phone numbers.) Otherwise, call or write your local U.S. IRS office. If you write to the IRS, be sure to include your social security number (or individual taxpayer identification number) in the letter.

5) I forgot to include interest income when I filed my return last week. What should I do?

To correct a mistake of this sort you should prepare Form 1040X. Include the omitted interest income, refigure the tax, and send the form as soon as possible along with any additional tax due to the Internal Revenue Service Center where you filed your return. Form 1040X can be used to correct an individual Form 1040 income tax return filed for any year for which the period of limitation has not expired (usually 3 years after the due date of the return filed, or 2 years after the tax was paid, whichever is later).

6) I am a U.S. citizen and, because I expect to qualify for the foreign earned income exclusion, all my foreign income (which consists solely of salary) will be exempt from U.S. tax. Do I get any tax benefit from income tax I paid on this salary to a foreign country during the tax year?

No. You cannot take either a tax credit or a tax deduction for foreign income taxes paid on income that is exempt from U.S. tax because of the foreign earned income exclusion.

7) I am a U.S. citizen stationed abroad. I made a personal loan to a nonresident alien who later went bankrupt. Can I claim a bad debt loss for this money?

Yes. The loss should be reported as a short-term capital loss on Schedule D (Form 1040). You have the burden of proving the validity of the loan, the subsequent bankruptcy, and the recovery or nonrecovery from the loan.

8) With which countries does the United States have tax treaties?

Table 6-1, at the end of chapter 6, lists those countries with which the United States has income tax treaties.

9) I am a retired U.S. citizen living in Europe. My only income is from U.S. sources on which I pay U.S. taxes. I am taxed on the same income in the foreign country where I reside. How do I avoid double taxation?

If you reside in a country that has an income tax treaty with the United States, that country may allow a credit against the tax you owe them for the U.S. tax paid on U.S. source income. Nontreaty countries, depending on their laws, may give the same type of credit against the tax you owe them for the U.S. tax paid on U.S. source income.

If double taxation with a treaty country exists and you cannot resolve the problem with the tax authorities of the foreign country, you can contact the U.S. competent authority for assistance. See chapter 6 for information on requesting consideration.

10) My total income after claiming the foreign earned income and housing exclusions consists of $5,000 taxable wages. Am I entitled to claim the refundable earned income credit?

No. If you claim the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, you cannot claim the earned income credit.

11) Last May my employer transferred me to our office in Puerto Rico. I understand that my salary earned in Puerto Rico is tax exempt. Is this correct?

As long as your employer is not the U.S. Government, all income from sources within Puerto Rico is exempt from U.S. tax if you are a bona fide resident of Puerto Rico during the entire tax year. The income you received from Puerto Rican sources the year you moved to Puerto Rico is not exempt. The tax paid to Puerto Rico in the year you moved to Puerto Rico can be claimed as a foreign tax credit on Form 1116.

12) I am a U.S. citizen married to a nonresident alien. Can I qualify to use the head of household tax rates?

Yes. Although your nonresident alien spouse cannot qualify you as a head of household, you can qualify if (a) or (b) applies:

a) You paid more than half the cost of keeping up a home that was the principal home for the whole year for your mother or father for whom you can claim an exemption (your parent does not have to have lived with you), or

b) You paid more than half the cost of keeping up the home in which you lived and in which one of the following also lived for more than half the year:

• Your unmarried child, grandchild, stepchild, foster child, or adopted child. A foster child will qualify you for this status only if you can claim an exemption for the child.
• Your married child, grandchild, stepchild, or adopted child for whom you can claim an exemption, or for whom you could claim an exemption except that you signed a statement allowing the noncustodial parent to claim the exemption, or the noncustodial parent provides at least $600 support and claims the exemption under a pre-1985 agreement.
• Any relative listed below for whom you can claim an exemption.

If your spouse was a nonresident alien at any time during the year and you do not choose to treat your nonresident spouse as a resident alien, then you are treated as unmarried for head of household purposes. You must have another qualifying relative and meet the other tests to be eligible to file as head of household. You can use the head of household column in the Tax Table or the head of household Tax Rate Schedule.

It may be advantageous to choose to treat your nonresident alien spouse as a U.S. resident and file a joint income tax return. Once you make the choice, however, you must report the worldwide income of both yourself and your spouse.

For more information on head of household filing status, get Publication 501, Exemptions, Standard Deduction, and Filing Information.

Penalties and Interest

1) Does the June 15 extended due date for filing my return because both my tax home and my abode are outside the United States and Puerto Rico on the regular due date relieve me from having to pay interest on tax not paid by April 15?

No. An extension, whether an automatic extension or one requested in writing, does not relieve you of the payment of interest on the tax due as of April 15 following the year for which the return is filed. The interest should be included in your payment.

2) If I wait to file my return until I qualify for the foreign earned income exclusion, I will be charged interest on the U.S. tax I will owe. To avoid being charged interest, can I file my return on time, reporting only my taxable income, excluding my salary for services abroad that will be exempt after I have met the qualifications?

No. If you file a return before you qualify for the exclusion, you must report all income, including all income for services performed abroad, and pay tax on all of it. After you meet the qualifications, you can file a claim for refund by excluding the income earned abroad. If you defer the filing of your return, you can avoid interest on tax due on your return to be filed by paying the tax you estimate you will owe with your request for an extension of time to file on Form 2350, or by paying enough estimated tax to cover any tax that you expect will be due on the return.