Foreign Tax Credits: A Complete Guide -

In a single year, taxpayers pay more than $1.6 billion in personal income tax. For instance, you may invest in foreign income-producing bonds, mutual funds, or stocks.

If so, it’s likely you paid foreign taxes on the income. However, what if you could avoid getting taxed a second time on your US tax return? You can do so with foreign tax credits.

Keep reading for a complete guide to foreign tax credits.

Contents

What Are Foreign Tax Credits?

You must pay US taxes on your income from foreign sources. With the following tips, however, you can save on your taxes.

The foreign tax credit equals your US tax obligation attributable to this income. Alternatively, it equals the amount of foreign tax that you’ve paid. You’ll pay whichever amount is less.

The foreign tax is a credit, not a deduction. The Internal Revenue Service (IRS) subtracts it directly from any taxes you owe.

An Example of the Foreign Tax Credit

Imagine you lived overseas and paid taxes in another country. In that case, you can subtract your tax payment there from your US tax return.

For example, suppose you work in Germany where you own a home. You might pay $6,000 on German income tax for the year.

In that case, you can claim a US foreign tax credit for $6,000. If you only earned $6,000 overseas and paid more taxes for some reason, however, the IRS would limit your tax credit to $3,000.

Why the Foreign Tax Credit Matters

All Americans must file United States income taxes, even if they live overseas. In other words, you must report your worldwide income to the IRS.

With the exception of Eritrea East Africa, the United States is the only country requiring all citizens to report their global income.

Most other countries only require individuals who make income in their regions to pay taxes. Otherwise, a government taxes only its own citizens. Also, if you’re an American citizen living in a foreign country, you must report your financial interests to the IRS.

In this instance, the IRS considers you an expatriate. These interests might include foreign:

• Bank accounts
• Business interests
• Financial assets
• Investments

However, the IRS maintains these requirements subject to minimum ownership thresholds.

Filing Foreign Taxes

If you’re an expatriate, you may have more filing requirements in another country. You may qualify as a tax resident because you live there.

Alternatively, you may simply have a source of income from another country. In these instances, the government of those countries may also require you to file and pay taxes.

If you were to move to another country permanently, you must pay taxes to that government. In that case, the government in that country might also collect taxes on your worldwide income.

Benefits of Foreign Tax Credits

You can claim the foreign tax credit against any US federal income tax. The credit covers any income tax payment you’ve me to a foreign government.

The IRS created the foreign tax credit to reduce the impact of paying taxes twice on the same income. For instance, without the tax credit rule, both the United States and the foreign country where you earn income might both hold you liable for paying taxes on the same earnings.

It’s possible that you live in more than one country. For instance, you could live in a different region during different times of the year.

This circumstance can complicate your tax situation. Still, it could qualify you to claim the foreign tax credit and take advantage of several other tax breaks.

Another Foreign Tax Scenario

Imagine you pay property tax on your home in Germany. The government would make it a requirement, and you would do so accordingly.

The German government would legally hold you liable for your property taxes. However, those property taxes aren’t eligible for the foreign tax credit. They’re not income taxes.

In the past, the IRS would have allowed you to deduct those property taxes as an itemized deduction for real estate taxes. However, the agency stopped this tax break in 2018.

Claiming Foreign Tax Credits

You must qualify to claim the foreign tax credit. First, you must fill out IRS Form 1116 along with your tax return.

The form will help you calculate the different limitations the IRS places on eligible tax credits. In some cases, however, you may not need to use Form 1116.

Instead, you can claim the full amount of your foreign taxes directly using Form 1040. You can also avoid calculating the limitations if you use this method.

However, you must meet some criteria to take the Form 1040 shortcut.

Simplified Foreign Income Tax Filing

For instance, you can file the foreign income tax credit on Form 1040 if all your foreign income was from investment income or interest and dividends. Also, you must have reported that income on Form 1099-INT, Form 1099-DIV, or Schedule K-1.

In addition, you must have foreign taxes that are equal to or less than $300. If you’re married and filing jointly, you can have foreign taxes of less than $600 and still qualify to use Form 1040 to file for your foreign tax credit.

You must also have held stocks or bonds that pay dividends or interest for at least 60 days. Also, you must not have been obligated to pay those amounts to someone else.

In addition, you must have legally owed all your foreign taxes. You must also not have eligibility for a refund or reduced tax rate under a tax treaty.

Finally, you must have paid taxes to countries recognized by the United States. Also, the country where you pay taxes must not support terrorism.

Qualifying Foreign Tax Credits

The IRS is facing challenging times. Accordingly, it’s vital to get your taxes right.

All the foreign taxes you pay aren’t eligible for the foreign tax credit. You must consider a few things to weigh whether you qualify for the credit.

For example, you must assess whether the tax was imposed on you personally. You must also have paid the tax.

You must also make sure that the tax liability is legal. You must also evaluate whether it was income tax or a tax in lieu of an income tax.

Assessing Qualifying Foreign Taxes

The IRS calls these kinds of assessments “tests.” You must answer yes to all these assessments to qualify for the foreign income tax credit. You will not qualify for the credit if you can’t answer yes to all the questions.

You must also consider the nature of the tax. For instance, you may find that you’re able to answer yes to all the foreign tax credit qualifying questions. Still, you may find that you’re not qualified for a foreign tax credit for one of several reasons.

For instance, a foreign government may have returned the tax payment to you or a family member as a subsidy. Alternatively, the tax payment may not have been required by law. In these cases, you won’t qualify for the foreign tax credit on your US tax return.

Foreign Tax Credit Compliance Rules

Foreign tax credit laws are highly complex. If you need help understanding foreign tax credit rules, you can refer to the IRS’s Foreign Tax Credit Compliance Tips.

Meanwhile, let’s have a look at common issues when it comes to claiming foreign tax credit.

Sometimes, the IRS taxes foreign dividends or capital gains at a reduced rate. In this instance, you must adjust your foreign tax credit using Form 1116.

You must also allocate any interest expense between the US and foreign source income. Usually, however, there’s no need to allocate charitable contributions against foreign source income, with a few exceptions. If your contributions were to charities based in Canada, Mexico, or Israel, you must allocate those contributions against your foreign source income.

More Foreign Tax Intricacies

Sometimes, the tax withheld by a foreign country is not the amount that qualifies for the foreign tax credit. For example, an income tax treaty between the United States and a foreign country may entitle you to a reduced foreign tax rate. In that case, only the reduced tax rate will qualify for the credit.

It’s your choice to file with the foreign country for a refund of the difference. In this instance, you’d file for the foreign tax credit that’s not allowed.

In other instances, you might receive a foreign tax determination. Most often, this situation will warrant a redetermination of your US tax liability as well.

In that case, you must file an IRS Form 1040-X or Form 1120-X. If you fail to do so, you could incur a penalty from the IRS.

When to Claim the Tax Credit

If you’re an expatriate, you can claim the foreign tax credit on foreign income taxes you’ve paid on non-US income. Again, however, the IRS must consider the tax legal.

For instance, you cannot claim a foreign tax credit on your property taxes in another country. Also, you must have already paid the tax.

If you meet these criteria, you can use the foreign tax credit to claim US tax credits to the exact dollar amount of your foreign income taxes.

In another scenario, you could have expatriate status and live abroad but also have a US-based income. For example, you may get paid by a US company and get taxed at the source.

Still, you’re liable for foreign taxes on your worldwide income. In this instance, you may have to claim tax credits to avoid double taxation.

Filing Taxes in Multiple Countries

In another scenario, you may have both US and non-US income sources. Here, you may need to claim both foreign and US tax credits.

In this instance, you might file one tax return and pay the full tax rate. When filing the other tax return, however, you’d claim tax credits.

Next, you’d need to file an amended version of your first return. Then, you can claim the other tax credits.

Is the Foreign Tax Credit Right for Me?

Not everyone can—or should—claim a foreign tax credit. For instance, you might have expatriate status and live in a country with lower income tax rates compared to the US.

Alternatively, you might move between countries without ever establishing residence. In that case, you may not need to file foreign taxes at all. Many American digital nomads find themselves in this situation.

How Rates Can Affect Taxation Liability

Suppose you live in a foreign country with a lower tax rate. In that case, a US foreign tax credit won’t erase your US tax liability.

You can only claim the US foreign tax credit on the value of the foreign income tax you’ve paid. In other words, you’ll most likely find you also have to pay US income taxes. You’d owe the difference between the foreign tax you’ve already paid and the US tax you owe.

Again, US digital nomads don’t have this issue. They never establish residency in any single country and aren’t held liable for foreign taxes.

The Child Tax Credit and Taxes

Relatively recently, the IRS changed the US child tax credit. In doing so, the agency allowed expatriates who have children with a US Social Security number to claim a $2,000 tax credit for their child.

Alternatively, the change allowed expatriates to reduce their US tax bills using foreign tax credits. This tax break came in the form of a $1,400 refundable tax credit per child.

If you’re an expatriate parent that can’t claim the Foreign Earned Income Tax Exclusion, you often can’t claim the refundable Child Tax Credit, however.

You could possibly eliminate your tax liability by claiming the Foreign Earned Income Exclusion. Alternatively, you could do so by claiming the Foreign Tax Credit. Given these options, you might find out that you’re better off claiming the Foreign Tax Credit so you can claim the refundable Child Tax Credit as well.

Foreign Tax Exclusions and Retirement

Many Americans find that Roth IRAs are useful pension savings plans. With this plan, you make post-tax contributions. Yet, distributions from a Roth IRA are tax-free.

However, suppose you’re an expatriate, and you exclude all your income by claiming the Foreign Earned Income Tax Exclusion. At the same time, you’ve earned no reportable earned income. In that case, you cannot make contributions to a Roth IRA.

On the other hand, suppose you claim the Foreign Tax Credit. As with the Child Tax Credit, you’ll find that you’re better off. You can claim the Foreign Tax Credit and make contributions toward your retirement through your Roth IRA.