By Jane Bruno, JD, LLM (Taxation)

June 2006

On May 17, 2006, President Bush signed into law tax legislation with the interesting title of “The Tax Increase Prevention Reconciliation Act of 2005”.  This awkwardly worded law seems to suggest that taxes would not increase, even though it holds out no promise of them being reduced.  But Americans living overseas will have a big surprise come tax filing time in 2007.  Not only will many expats owe more US tax, but they will find the tax changes apply retroactively to January 2006.

 How did this happen?   It seems that Senator Grassley (R-Iowa) pushed through these provisions at the eleventh hour so there was not time to mount a meaningful lobby against them.  Keep in mind, though, that there have been other attempts to erode the tax benefits of living overseas.  The last effort several years ago would have eliminated the foreign income exclusion entirely and was introduced by a Democrat!

  What exactly has been changed in the tax law for expats?  There are three primary changes, any one of which may or may not affect you.

 Number One

 The good news first:  The foreign earned income exclusion will actually increase in 2006 to $82,400 (up from $80,000). The exclusion was scheduled to be indexed for inflation in 2008 in any case, and the new law just puts that in place sooner. 

Number Two

 The foreign housing exclusion has been capped at 30% of the earned income exclusion (minus 16% of the foreign income exclusion or $11,586 for 2006) whereas formerly there was no cap at all on this exclusion. The housing exclusion is in addition to the foreign income exclusion and was originally designed to help offset the higher cost of overseas housing, using an assumption that housing in the US would cost an amount equal to 16% of the salary of a US government employee grade GS-14, step 1.  The theory, notwithstanding this rather random selection of a dollar value, was that Americans living overseas should not be penalized by having higher housing costs and also potentially having to pay tax on money given by their employer to help offset that housing cost.

 So, in a simple example, suppose Mr. Taxpayer has $85,000 of foreign income and is reimbursed $4,000 a month for his housing.  His total income is $133,000 ($85,000 + $48,000).  Under the old law, Mr. T could exclude $80,000 in income and $36,106 in housing expense ($48,000 - $11,894 (the base housing amount in 2005)) for a total of $116,106.

 Under the new law, same facts, Mr. T could exclude $82,400 in income and $13,134 in housing exclusion (30% of $82,400 – $11,586) for a total of $95,534.  This means Mr. T will have to report an additional $20,572 in taxable income.

 NOTE #1:  In high tax countries, some or all of the US income tax may be offset by the foreign tax credit which remains unchanged.

 NOTE #2:  There is authority in the new law for the housing cost limitation to be adjusted based on geographic differences in housing costs.

 Number Three

 The potentially most expensive change for Americans overseas provides that income and housing expense excluded for tax purposes must be included for purposes of determining the marginal tax rate on other taxable income.

 Applying this to the example above, under the old law, Mr. T was subject to tax on $16,894 (the difference between $133,000 and $116,106).  His marginal rate would be that of a taxpayer with $16,894 of income (around 10.6 % for married, filing joint).  Under the new law, Mr. T would be taxed on $37,466 of income (the difference between $133,000 and $95,534) and that income would be taxed at the marginal rate of a $133,000 income taxpayer (around 35.7 %).

 Summary

 These changes have caused quite a stir in the expat community.  Some taxpayers won’t be affected at all (especially those that make below the exclusion amount, live in high tax countries, or mostly live on retirement income which is taxed anyway).  Others will see their US taxes rise dramatically.  If you are among the latter group, you may want to join the effort to have this tax provision repealed.

 Jane Bruno is a tax consultant with 20 years experience with overseas taxpayers, and the author of “The Expat’s guide to US Taxes”.  If you have any questions, please feel free to contact her at: janebruno@adelphia.net.