Because the United States taxes you on your worldwide income, you may be double taxed. If you are living and working outside the United States, you can take advantage of the foreign earned income exclusion, which exempts a certain amount of your offshore earned income from U.S. income tax. In addition, if your employer is a foreign person, you do not have to pay supplementary taxes like Social Security or Medicare. To take advantage of this exclusion, you must reside outside the United States for at least 330 days in any twelveconsecutive- month period. The United States also has tax treaties with some countries that permit you to receive credit for taxes you may have to pay in the United States and also in the country of investment.
In countries that have high tax rates on earned income, the foreign tax credit may be a better option than the exclusion of foreign earned income. For example, France imposes a tax rate of 45 percent on your earnings, but in the United States, the tax rate is 33 percent. So if you earn $100,000, the tax is $45,000 in France but only $33,000 in the United States. You can thus offset your U.S. tax 100 percent by $33,000 of the tax paid to France, with your total taxes then being $45,000. If you choose to use the foreign earned income exclusion, which was $82,400 in 2006, with an income of $100,000, you would pay U.S. taxes on the remaining $17,600. The French tax that you would pay on the amount that is excluded from U.S. tax cannot be used as a tax credit in the United States, but you would still get a credit for the foreign taxes paid on the $17,600 remaining. Basically, you could still end up paying $45,000 to France and zero taxes to the United States, but other combinations of tax rates between the two countries could produce different results. Generally, if the U.S. tax rates are higher, the foreign earned income exclusion is better than the foreign tax credit.
The U.S. foreign tax credit is not limited to taxes on earned income. As a foreign investor, you may be subject to income taxes, real estate gains, or other capital gains. You can claim a credit to offset your U.S. taxes for the taxes paid to that country, but not in excess of the taxes you would pay on the same income in the United States.
In many countries, real estate transactions are subject to a valueadded tax (VAT), which is roughly equivalent to a flat tax. The VAT replaces high income taxes in some countries by distributing tax loads on goods, services, and investments. The Internal Revenue Service (IRS) does not consider a VAT to be an income tax, but it is deductible as an expense. It cannot be used as any part of the tax exclusion calculation.
Currency gains or losses that you incur when selling an investment are considered a capital gain or loss. A currency gain in connection with a trade or business or with the management or administration of investment assets is treated as an ordinary gain (rather than a capital gain), and any loss is generally treated as an expense.