The foreign tax credit can be claimed against any U.S. federal income tax owed when an American also pays income tax to a foreign government. The purpose of this credit is to reduce the impact of having the same income taxed by both the United States and by the foreign country where the income was earned.
Some people live on more than one patch of soil, residing in different countries at different times during the year. This can complicate your tax situation, but you might be eligible to claim this credit or one of two other tax breaks to ease the sting a little.
What Is the Foreign Tax Credit?
The foreign tax credit is equal to the U.S. tax attributable to a taxpayer’s foreign-source income or the amount of foreign tax paid, whichever is less. As a credit, it subtracts directly from any tax debt you might owe the IRS when you complete your U.S. tax return.
How Does the Foreign Tax Credit Work?
As an example, Jorge and Roberta own a house in Germany and Jorge is also employed there. He pays $6,000 to Germany in income tax for the 2019 tax year. Jorge can claim a U.S. tax credit on his 2019 tax return for that $6,000. His credit would be limited to $3,000 if Jorge only earned that much and for some reason paid more in taxes, maybe because penalties were added on.
Now let’s say that Jorge and Roberta pay property tax on their Germany home each year. The tax is imposed on them and they actually pay it, and the amount paid is the legal and actual amount of their tax liability. But this tax isn’t eligible for the foreign tax credit because it’s not an income tax.
It used to be that Jorge and Roberta could deduct these property taxes as an itemized deduction for real estate taxes instead, but that tax provision was eliminated by the Tax Cuts and Jobs Act (TCJA) in 2018. The deduction for U.S. real estate taxes still exists, but foreign property taxes no longer qualify.1
The Credit vs. the Foreign Earned Income Exclusion
The IRS also offers a foreign earned income exclusion. People who work in foreign countries and who earn wages or self-employment income there will often pay taxes on that income to the foreign governments. These taxpayers can exclude some or all of their foreign earned income from their U.S. federal income tax.
You can’t claim both the foreign tax credit and the foreign earned income exclusion on the same income in the same tax year.
You can claim a foreign tax credit on the income that was not excluded from tax if only part of your wages or self-employed income is excluded.
|Foreign Tax Credit||Foreign Earned Income Exclusion|
|Subtracts from your tax liability to the IRS||Isn’t included in taxable income on a U.S. return|
|Worth the amount of tax paid to a foreign government or wages earned there, whichever is less||Worth up to $107,600 per person as of the 2020 tax year|
The Credit vs. the Deduction
You can also claim an itemized tax deduction for foreign income taxes rather than take the foreign tax credit. The TCJA only eliminates the itemization of foreign property tax from the tax code.
Even the IRS acknowledges that claiming a credit rather than a deduction is generally better for most taxpayers, but speak to a tax professional to make sure this is the case for your personal tax situation.2
Include your foreign taxes on Schedule A with your tax return if you decide to claim the itemized deduction rather than the foreign tax credit. Again, you can’t do both.
|Foreign Tax Credit||Itemized Deduction for Taxes Paid|
|Subtracts from tax liability to the IRS||Subtracts from taxable income|
|Doesn’t prohibit claiming the standard deduction||Can’t be claimed as an itemized tax deduction in addition to claiming the standard deduction|
Requirements for the Foreign Tax Credit
Not all taxes paid to a foreign government are eligible for the foreign tax credit. Ask yourself the following questions to find out if you qualify:
- Is the tax imposed on you?
- Did you pay or accrue the tax?
- Is the tax a legal and actual foreign tax liability?
- Is the tax an income tax or a tax in lieu of an income tax?3
The IRS refers to these questions as “tests.” You must affirmatively pass each of them. You won’t qualify if you can’t answer yes to all four of these questions.
The nature of the tax matters as well. You might meet all the above criteria but still not be able to claim the foreign tax credit due to a few reasons:
- The tax was refundable or otherwise returned to you as a subsidy to you or a member of your family
- Paying the tax wasn’t required by law
- The tax was withheld from dividends, gains, or income that didn’t meet required minimum holding periods3
How to Claim the Credit
You can claim the foreign tax credit if you qualify by completing and filing IRS Form 1116 with your tax return. This form calculates the various limitations placed on the amount of the tax credit that you’re eligible for.4
You might not have to use Form 1116 to claim the credit, however. You can claim a credit for the full amount of foreign taxes paid directly on your Form 1040 without calculating the various limitations if each of the following statements on Form 1116 is true:
- All your foreign source gross income was from interest and dividends.
- All that income and the foreign tax paid on it were reported to you on Form 1099-INT, Form 1099-DIV, or Schedule K-1.
- The total of your foreign taxes is equal to or less than $300, or $600 if married filing jointly.
- You held the stock or bonds on which the dividends or interest were paid for at least 16 days and were not obligated to pay these amounts to someone else.
- You are not filing Form 4563 or excluding income from sources within Puerto Rico.
- All of your foreign taxes were legally owed and were not eligible for a refund or a reduced tax rate under a tax treaty, and they were paid to countries recognized by the United States and do not support terrorism. The IRS puts it this way: “You paid the tax to a country for which a credit is not allowed because it provides support for acts of international terrorism, or because the United States does not have or does not conduct diplomatic relations with it or recognize its government and that government is not otherwise eligible to purchase defense articles or services under the Arms Export Control Act.”5
You can’t carry forward any unused foreign tax credit to another tax year if you don’t submit Form 1116. This credit isn’t refundable, so you can only claim the amount up to your tax liability to the IRS for that particular year. But the balance won’t be wasted if you also file Form 1116, because you can then roll the leftover portion to a future tax year.3
- The idea behind the foreign tax credit is to avoid having Americans pay income tax on the same income twice, once to the U.S. and again to a foreign jurisdiction where it was earned.
- The credit is equal to any income tax you paid to a foreign government for income earned there, or to the amount of income earned if this amount is less.
- You have the option of claiming this credit or excluding your foreign income from your U.S. tax return if you paid income tax on the earnings to another country, but you can’t do both.
- You can also claim an itemized deduction for income taxes paid to another country, but you can no longer deduct foreign property taxes, and you can’t claim both a deduction and the credit.