Foreign Income and Living Expense Exclusion
By Dave Burt, CPA -
As a U.S citizen or resident alien your worldwide income is generally subject to U.S. income tax. However, the IRS allows a foreign income and living expense exclusion for those having a tax home (living and working) overseas. The maximum foreign earned income exclusion for 2007 is $85,700, which is multiplied by the ratio of the number of days in country divided by 365. E.g., $85,700 x 365 days in country / 365 days a year = your maximum income exclusion.
In addition, if your employer contributed to your housing and included that amount in your wages, you may also be able to deduct a portion subject to (1) a limit (varies by country but usually, $24,720) and (2) by a housing exclusion base @ $36.12 per in country day. From our example above, 356 days in country x $36.12 per day = $13,184 exclusion base.
You had personal service income of $185,000 for a full calendar year in country inclusive of employer paid living expenses of $35,000 (they paid 100% of your qualified living expenses.) Your host country has a $24,720 limit set by the IRS. So, $24,720 limit – 13,184 base = 11,536 over base. Then: $11,536 over base x 18% ($35,000 100% employer provided living expenses / $185,000 total income) = $2,076 housing exclusion. Finally, add together your maximum foreign earned income exclusion of $85,700 and your housing exclusion of $2,076 = $87,776. Then, from this amount subtract any deductions that are allocable to the excluded income. The result would be deducted from you total income using Line 44, Form 1040. Whew!
You may want to check to see if you are subject to your host country’s income tax laws. I think the reason for the exclusions originally was to lessen the double taxation burden on overseas workers. See tax history link: http://www.aca.ch/hisustax.htm 
Check out the following links for updates and rate changes. And think about contracting a local CPA for individual tax advice before you make a decision:
David Burt, CPA, So. Cal.