You should plug it in to TaxAct and see how it is handled. When I prepared my daughter's return this year, TurboTax placed her foreign earned income on line 19 of form 2555, and added it also to line 7 on form 1040. TurboTax then subtracted it out on 1040 line 21, but since there was also other positive income also being posted to line 21, it generated a separate statement showing the foreign income exclusion (negative) and other foreign income (positive) that led to the line 21 entry.
Try entering this stuff into TaxAct or TurboTax and seeing how it goes, rather than speculating.
You can use the average rate from any government or banking source. The US Federal Reserve Board gives 1.0300, and the Bank of Canada gives 1.02991480 (the Bank of Canada seems to suffer from what might be called "delusions of accuracy"). I used 1.03 myself as the yearly average. This means that CAD 10,000 of income would get posted to your 1040 (or 2555) as 10,000/1.03 = 9,708.74 USD, or USD 9,709 if you are using whole dollars only. Bear in mind that if you have any large one-time exchanges (for example, lump sum pension payout, sale of a stock or bond), you should use the exchange rate on that day.
I don't understand your statement "How would the US government know?". You are going to tell the US government on your tax return how you are handling it, and because you will be correct, that will be the end of it. (If you try to cheat them though, be very aware that the US and Canadian governments exchange immense amounts of information on taxes.)
2 Canadians living in the USA
Moderator: Mark T Serbinski CA CPA