The foreign tax credit is a remarkable tool for U.S. citizens and resident aliens, allowing them to offset the income tax paid to foreign countries. This helps prevent double taxation on the same income, providing significant relief financially.
Key Takeaways
- The foreign tax credit helps reduce U.S. tax liability for income tax paid to other countries.
- Available to U.S. citizens and residents earning income abroad who have paid foreign income taxes.
- Foreign taxes on income, wages, dividends, interest, and royalties generally qualify.
How the Foreign Tax Credit Works
Paying taxes to a foreign country or U.S. possession doesn’t mean you need to pay U.S. tax on the same income without relief. Here’s how you can benefit:
If you take an itemized deduction, file it on Schedule A of your 1040 or 1040-SR. On the other hand, an option for direct reduction of your U.S. tax liability is taking the credit, which requires completing Form 1116. Importantly, you must choose either a deduction for all qualified foreign taxes or a credit; mixing them or claiming both isn’t permissible.
Choosing the credit often makes more financial sense as it directly reduces your tax bill rather than just decreasing your taxable income. Only certain types of foreign taxes, such as those on income, war profits, and excess profits, are eligible.
Foreign income tax must generally be comparable to a U.S. income tax. This includes taxes on wages, dividends, interest, and royalties—not payments for specific economic benefits. Additionally, foreign property taxes might be deductible under certain circumstances on your Schedule A.
Individuals, estates, and trusts can utilize this credit to lower their income tax burdens. Unused foreign taxes can be carried back one year or forward for up to ten years.
Do I Qualify for a Foreign Tax Credit?
To claim this credit, ensure:
- The tax was imposed on you by a foreign country or U.S. possession.
- You paid or accrued the foreign tax in the same year.
- The tax is legally your liability, not merely reimbursed or subsidized.
- The tax must be an income tax or substitute.
Although there’s a cap on the credit amount you can claim, you can calculate it on Form 1116. In some cases, such as when only passive income is involved, small foreign taxes (under $300, or $600 if married filing jointly), and income reported on specific forms (like 1099-DIV), you may claim the credit directly on Form 1040.
If opting for the foreign earned income exclusion or the housing exclusion, you cannot claim the foreign tax credit on the excluded income.
Refundable vs. Non-refundable Tax Credits
Tax credits come in two types: refundable and non-refundable.
Refundable tax credits allow you to receive the excess amount as a refund if the credit exceeds your tax due. In contrast, non-refundable tax credits, like the foreign tax credit, only reduce your tax owed to zero; any excess can’t be refunded.
Tax Credits vs. Tax Deductions
The key difference between tax credits and tax deductions lies in their impact. Tax credits reduce your tax bill dollar-for-dollar, offering more value. For example, a $1,000 tax credit lowers your tax directly by $1,000. Conversely, a tax deduction reduces taxable income, thus diminishing the taxable amount indirectly. In the 22% tax bracket, a $1,000 deduction saves you $220.
Foreign Tax Credit vs. Foreign Earned Income Exclusion
Both these tools help avoid double taxation but have different focal points. The foreign tax credit applies to earned and unearned income such as dividends and interest, whereas the foreign earned income exclusion strictly applies to earned income.
Who Can Claim the Foreign Tax Credit?
If you’re a U.S. citizen or resident, your worldwide income is taxable in the U.S., no matter where you live. This credit is a lifeline to avoid double taxation. Bona fide residents of Puerto Rico and nonresident aliens with U.S. business income also qualify.
The Bottom Line
The foreign tax credit is an indispensable tax tool for offsetting income tax paid to other nations, making it possible to prevent double taxation on your earnings. Ensuring you qualify and accurately claiming this credit requires fulfilling certain conditions, but it’s well worth the effort for the significant financial relief it provides.
Related Terms: double taxation, refundable tax credit, non-refundable tax credit, foreign earned income exclusion
References
- Internal Revenue Service. “Foreign Tax Credit - Choosing To Take Credit or Deduction”.
- Internal Revenue Service. “Foreign Taxes That Qualify for the Foreign Tax Credit”.
- Internal Revenue Service. “Foreign Currency and Currency Exchange Rates”.
- Internal Revenue Service. “Topic No. 856 Foreign Tax Credit”.
- Internal Revenue Service. “Foreign Tax Credit—How to Figure the Credit”.
- Internal Revenue Service. “Instructions for Form 1116, Foreign Tax Credit (Individual, Estate, or Trust)”, Page 23.
- Internal Revenue Service. “Choosing the Foreign Earned Income Exclusion”.
- Tax Policy Center. “What is the Difference Between Refundable and Nonrefundable Credits?”
- Internal Revenue Service. “Credits and Deductions for Individuals”.
- Internal Revenue Service. “Publication 514, Foreign Tax Credit for Individuals”, Page 9.
