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The IRS does understand the predicament that is presented by moving and living overseas. The cost of living is simply not comparable. To not discourage Americans from moving overseas, the IRS allows expats to deduct certain housing expenses from their reported gross income. This deduction is referred to as the Foreign Housing Allowance (more specifically the Foreign Housing Exclusion or the Foreign Housing Deduction). This allowance will vary depending on your overseas location. In order to qualify for the allowance, you will need to spend enough time overseas to pass either the "bona fide resident" or "physical presence" test. Simply put, you need to actually live overseas to qualify. The Housing Exclusion applies to employed individuals (amounts paid by employers may be deducted), and the Housing Deduction applies to self-employed individuals.
Of course, there are limits as to how much and how many of your expenses you can deduct, and these limits are determined by the Foreign Earned Income Exclusion's limits (as a side note: you can claim the income exclusion, the housing exclusion, or both, but you can't exclude the same income for both). The 2010 FEIE is set at $91,500 (meaning that is the amount of foreign earned income that can be excluded from income reported to the IRS, if the FEIE is claimed). In regards to your housing deduction, you can normally expect to deduct no more than 30% of the FEIE limit. So, in 2010, one could deduct up to $27,450 (30% of $91,500). Things you can exclude until the deduction limit is reached are: necessary housing repairs, rent, water, gas, electricity, property insurance, parking and furniture/appliance rental. Things deemed lavish or unnecessary, such as pay television, will not qualify as deductions. Other things that do not qualify are taxes, domestic labor (maids, cooks, etc.), furniture purchases and property depreciation. Many expenses fall into an obvious category of need or want, but when the line is blurry, it is important to seek the advice of a professional.
In 2006, the Treasury and IRS began making adjustments for specific locations due to the extreme differentiation in the cost of living from that of the US. The IRS has since deemed over 400 locations to be exceptions to the 30% maximum deduction ceiling rule, and it has expanded the maximum limit for deductions for expats living within those locations. Examples of these higher allowances are London at $83,400; Singapore at $67,000; and Hong Kong at $114,300. Visit the IRS' list for details on all applicable locations.
Now that you're beginning to understand the housing allowance, you will want to delve into how much you, personally, will be able to deduct. First, you should consider how much you will not be able to deduct (the amount the IRS feels you would be paying if still in the US). This non-deductible amount is currently calculated as 16% of the FEIE, and this calculation is the same for everyone, regardless of location. With the FEIE at $91,500, the current amount that is required (completely non-deductible) is $14,640. It is important to calculate this amount in days ($40.11 per day), because days spent in the US will not count toward your deductible amount. Now, if you live in Singapore, where the current allowance is $67,000 ($183.56 per day), and you spend 352 days outside of the US ($183.56 - $40.11) * 352, your deductible amount will be $50,494.40. Of course, knowing the exact amount you can deduct does not automatically tell you what to deduct. This can be a complicated process and should usually involve the help of a professional. In addition to the housing expenses mentioned above, employed individuals may also be able to deduct tax equalization and childcare/education expenses that are paid for by the employer.
Self-employed expats will not qualify for the foreign housing exclusion. But they can take advantage of the foreign housing deduction by deducting applicable housing expenses from their gross income. While the Foreign Housing Deduction will lower your overall tax liability, it will not reduce the Self-Employment Tax liability burden.
As mentioned before, you cannot doubly claim income with the FEIE and the Housing Allowance. This is another issue that should be addressed with an international tax professional. Normally, it is wise to claim the housing allowance for income exceeding the FEIE limits.
Whether by way of the exclusion or the deduction, the Foreign Housing Allowance is a strictly voluntary matter. You will only be able to claim these allowances by filling out and including Form 2555 with your Federal Tax Return. The simplified Form 2555 EZ cannot be used for the housing exclusion or the deduction. The foreign housing deduction is reported on Form 2555 Part VI and IX. This deduction amount is then reported on Form 1040 Line 36, indicating "Form 2555" in the space provided.