If you are a U.S. citizen or a resident alien of the United States and you live abroad, you are taxed on your worldwide income. However, you may qualify to exclude from income up to an amount of your foreign earnings that is now adjusted for inflation ($91,400 for 2009, $91,500 for 2010, $92,900 for 2011, $95,100 for 2012). In addition, you can exclude or deduct certain foreign housing amounts.
You may also be entitled to exclude from income the value of meals and lodging provided to you by your employer. Refer to Exclusion of Meals and Lodging in Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, and Publication 15-B, Employer's Tax Guide to Fringe Benefits for more information.
You can refer to the following IRS webpage for more detailed information relating to the exclusion:
You will use Form 2555 to take the exclusion.
Link to Form 2555/instructions:
Foreign Tax Credit Information:
If you paid or accrued foreign taxes to a foreign country on foreign source income and are subject to U.S. tax on the same income, you may be able to take either a credit or an itemized deduction for those taxes. Taken as a deduction, foreign income taxes reduce your U.S. taxable income. Taken as a credit, foreign income taxes reduce your U.S. tax liability. In most cases, it is to your advantage to take foreign income taxes as a tax credit.
Once you choose to exclude either foreign earned income or foreign housing costs, you cannot take a foreign tax credit for taxes on income you can exclude. If you do take the credit, one or both of the choices may be considered revoked.
You would use the Form 1116 to take the Foreign tax credit.
Link to Form 1116/instructions:
Firstly thanks for what I assume is an accurate and comprehensive answer to my dilema. I have a lot to do before I know how comprehensive an answer you have given me. I was rather hoping for you to tell me I had nothing to do and that everything would go away on its own but I guess things do not work that way. One more (for the moment) question. Can I file the last seven (someone else told me it was six) years with one form or do I have to go through the entire procedure seven times. Thanks, Duncan