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Taxed and Taxed Again!

Previously in an article entitled New tax legislation set to hit Americans abroad (The Portugal News, 20 May 2006), this writer informed readers that the most costly tax increase affecting American expatriates in 30 years would be felt in the 2006 tax filing season.  As Americans abroad should know by now, taxes owed Internal Revenue Service for 2006 were due 16 April 2007, even though the tax filing deadline is 15 June 2007.  Americans who are accustomed to filing their own tax returns are more likely to miss this payment deadline under the incorrect assumption they owe no taxes.

Consider John Reardon, married and a resident in Iberia since 1990.  He owns a small incorporated business from which he paid himself $66,300 in 2006.  Were this salary his only source of income, he would owe no tax thanks to the Foreign Earned Income Exclusion that was raised last year to $82,400.  However John had other income totaling $67,300 that included interest, ordinary and qualified dividends, capital gain distribution, social security, and gain from sale of property.  After reductions for Exemptions ($6,600) and Standard Deduction ($12,300), his taxable income was $48,400. 

Figuring the tax from the graduated tax table for married joint, John owed $6,500.  Due to his having had qualified dividends and capital gain distribution, John might have figured his tax from the Qualified Dividends and Capital Gain Worksheet and more correctly reported a liability of $6,350.  But this difference of $150 ($6,500 - $6,350) is not really significant unless you depend on McDonald’s fare for daily nourishment.  Nevertheless John was pleased because his estimated tax payments exceeded his tax liability. 

The shocking truth, however, is that John should have figured his tax on the new Foreign Earned Income Tax Worksheet.  This worksheet, together with the Qualified Dividends and Capital Gain Worksheet, requires that he first calculate his tax liability on $114,700 ($67,300 + $66,300 – (12,300 + 6,600)) and NOT on $48,400 (67,300 – (12,300 + 6,600)).  The resulting tentative tax is $21,650.  This tax may then be reduced by $9,700 tax on his Foreign Earned Income.  The result is that John actually owes $11,950 (21,650 – 9,700). 

Had the law – Tax Increase Prevention and Reconciliation Act - not been enacted, John would have owed $6,350 (see above).  Now he will be liable for the extra tax plus underpayment penalties: .5% a month (up to 25%) plus 8% interest.

Alas John made another error in anticipating his tax liability.  Having purchased a property stateside on 15 July 2005, he sold it on 1 July 2006 for a hefty $55,000 profit.  As a short term capital gain, the profit was taxed as ordinary income rather than as capital gain.  The unfortunate result was that he paid $5,500 in additional taxes!  In other words, had he delayed the sale by two weeks, his tax liability would have been $6,450 rather than $11,950 (unless delaying the sale might have meant losing the sale).

Still it pays to talk to the tax consultant.