Content of the material
- What Is the Foreign Tax Credit?
- Key Takeaways
- Foreign Housing Exclusion or Deduction
- Step One: Find Out If You Qualify for the Foreign Tax Credit
- How Does the Foreign Tax Credit Work?
- Claiming the Child Tax Credit
- When should expats claim the Foreign Tax Credit?
- US Foreign Tax Credit Calculation
- Foreign Withholding Taxes
- Qualifying for FTC
- Requirements for the Foreign Tax Credit
- How Do the Foreign Tax Credit and Foreign Earned Income Exclusion Differ?
- Foreign Tax Credit limitations rules for U.S. citizens abroad
- The tax must be imposed on you
- You must have paid or accrued the foreign tax
- The tax must be the legal and actual foreign tax liability
- The tax must be an income tax
- What are the qualifications for claiming the foreign tax credit?
- 1. The tax must be imposed upon you
- 2. You must have paid or accrued the tax
- 3. The tax must be the legal and actual foreign tax liability
- 4. The tax must be an income tax
- How do I claim the foreign tax credit?
- Forms you’ll need
- Can you carry it forward?
What Is the Foreign Tax Credit?
The foreign tax credit is a U.S. tax credit used to offset income tax paid abroad. U.S. citizens and resident aliens who pay income taxes imposed by a foreign country or U.S. possession can claim the credit. The credit can reduce your U.S. tax liability and help ensure you aren’t taxed twice on the same income.
Key Takeaways The foreign tax credit is a U.S. tax break that offsets income tax paid to other countries.The credit is available to U.S. citizens and residents who earn income abroad and have paid foreign income taxes.Foreign taxes on income, wages, dividends, interest, and royalties generally qualify for the foreign tax credit.
Foreign Housing Exclusion or Deduction
In addition to the foreign earned income exclusion, there is an exclusion for employer provided housing. For the self-employed, it is a deduction instead of an exclusion. The amount of the foreign housing exclusion or deduction is capped at 16 percent of the foreign earned income exclusion. However, for certain high cost foreign cities and countries, the IRS allows for an increased maximum foreign housing exclusion or deduction. The list of these localities is published in the instructions to Form 2555.
Importantly, employer provided housing for purposes of this exclusion include certain tax equalization payments made by an employer and certain education expenses for dependent children.
Step One: Find Out If You Qualify for the Foreign Tax Credit
- You must have incurred or paid a foreign tax liability.
- The tax must be assessed on income.
- The tax must be imposed on you as an individual.
- The tax must have originated legally in a foreign country.
How Does the Foreign Tax Credit Work?
As an example, suppose 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 2021 tax year. Jorge can claim a U.S. tax credit on his 2021 tax return for that $6,000. His credit would be limited to $3,000, however, if Jorge were only to earn that much and for some reason were to pay more in taxes.
Now suppose that Jorge and Roberta pay property tax on their home in Germany home each year. The tax is imposed on them, and they pay it. 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 actually an income tax.
It used to be that Jorge and Roberta could deduct these property taxes as an itemized deduction for real estate taxes, but that tax provision was eliminated by the Tax Cuts and Jobs Act (TCJA) in 2018.
Claiming the Child Tax Credit
The US Child Tax Credit changed as part of the recent tax reform, allowing expats with children who have US social security numbers to claim either a $2,000 tax credit per child, or, if they have already reduced their US tax bill to zero using tax credits, a refundable $1,400 refundable tax credit (i.e. payment) per child.
Expat parents who claim the Foreign Earned Income Exclusion often can’t claim the refundable child tax credits though, meaning expat parents who could eliminate their US tax liability by either claiming the Foreign Earned Income Exclusion or the Foreign Tax Credit may be better off claiming the latter so that they can claim the refundable Child Tax Credit too.
When should expats claim the Foreign Tax Credit?
Not all expats can, or should, claim the Foreign Tax Credit.
For example, some expats either live in a country where the income tax rates are lower than in the US, or move between countries without establishing tax residence in any single one, so that they aren’t required to file foreign taxes at all. (such as many American Digital Nomads).
If expats pay foreign income tax at a lower rate than the US rate, claiming the US Foreign Tax Credit won’t eradicate their US tax liability, as they can only claim US tax credits based on the value of foreign income tax that they’ve paid, so they would have to pay some US tax too (the difference between the foreign tax they’ve paid and the US tax they owe).
Expats such as Digital Nomads who don’t pay any foreign tax as they are moving from country to country without establishing tax residency in any single one, or expats who live in a country that doesn’t charge income taxes (either at all, or on income not paid in that country), won’t be able to claim the Foreign Tax Credit.
Other IRS provisions exist to help these expats reduce (and hopefully eliminate) their US tax bill, notably the Foreign Earned Income Exclusion.
The Foreign Earned Income Exclusion allows expats to simply exclude the first around $100,000 of their earned income from US taxation. The exact amount is increased a little each year based on inflation.
Earned income includes all income that is paid for services provided, such as salaries, wages, self-employment income, tips, and bonuses, but not passive income such as dividends, interest, rental or pension income, or social security benefits, capital gains, or alimony.
(The Foreign Tax Credit on the other hand doesn’t distinguish between earned and unearned income, so long as foreign income taxes have been paid on it.)
To claim the Foreign Earned Income Exclusion, expats must also demonstrate that they meet one of two IRS definitions of living abroad. The first is that they spend at least 330 full days in a 365 day period that is normally the tax year outside of the US (this is called the Physical Presence Test), and the second is that they are a permanent resident in another country (this is called the Bona Fide Residence Test).
Expats who earn over $100,000 and who rent their home abroad can additionally exclude a proportion of their housing expenses by claiming the Foreign Housing Exclusion (or the Foreign Housing Deduction for self-employed expats). Both the Foreign Earned Income Exclusion and the Foreign Housing Exclusion (and Deduction) can be claimed on IRS Form 2555.
In general, expats who live in a single foreign country and pay foreign income tax at a higher rate than the US rate on all of their global income are generally best off claiming the Foreign Tax Credit. Expats who either don’t pay foreign taxes or who pay them at a lower rate, whose only income is earned (and doesn’t exceed over $100,000), and who can meet either the Physical Presence Test or the Bona Fide Residence Test are generally better off claiming the Foreign Earned Income Exclusion.
Expats whose circumstances don’t fit into either of the above categories may need to claim a combination of IRS provisions, and may still end up owing some US tax.
The bottom line is that no expat should end up paying more than the higher of the two income tax rates that they’re subject to in total. All expats should seek advice from a US expat tax specialist though to ensure that they pay the least possible tax that they need to.
US Foreign Tax Credit Calculation
Your tax credit cannot be more than your total U.S. tax liability multiplied by a fraction. The numerator of the fraction is your taxable income from sources outside the United States. The denominator is your total taxable income from U.S. and foreign sources.
In order to see how much you can claim, please multiply the total amount of your foreign source taxable income (before tax exemptions) with the total US tax you need to pay.
For the tax year, George made $100,000 in the US, but also made $50,000 in Italy (after converting Euros to US Dollars). He also owes $10,000 in US taxes.
Therefore, George’s total income is $150,000 and one-third of that income ($50,000) is foreign-sourced. He can receive $3,300 as the maximum credit ($10,000 x 1/3).
Foreign Withholding Taxes
Many countries, the United States included, want to tax shareholders of corporations incorporated within their boundaries on the dividends they receive. For domestic shareholders, that’s relatively easy. Domestic shareholders will file tax returns in the same jurisdiction as the paying corporation. But what happens if, for example, a Japanese corporation pays a dividend to an individual who lives in the United States?
Japan (fortunately) does not require a U.S. shareholder to file a tax return in Japan. However, the Japanese government requires the Japanese corporation to withhold a percentage of the dividend initially payable to the shareholder and pay it to the government. If the shareholder is an American, the rate of withholding is generally 10 percent. Here is an illustrative example:
Example: Tony is an American citizen. He owns 100 shares of Toyota stock in a taxable account. Toyota is incorporated in Japan. Toyota pays a dividend to its shareholders (in Yen) in an amount equal to $1.00 per share ($100 total to Tony). Under the U.S. – Japan tax treaty, Toyota must withhold ten percent of the dividend ($10) and remit it to the Japanese government. Thus, Tony receives a $90 net dividend from Toyota.
Qualifying for FTC
How can you be sure you qualify for the Foreign Tax Credit? First, make sure that taxes you are paying in the foreign country you are working in, is imposed on you. Meaning, by law you must pay taxes in a foreign country and so, you carry forward this responsibility.
Then, only a certain type of finances can qualify for this credit. In the most common case, it is personal income, which includes everything from wages, and business income to investment income.
By using the Foreign Tax Credit, you are reducing your US taxable income as an American abroad. Additionally, when you use the FTC for credit onto your own US taxes, you lessen the burden of your US tax liability.
If you want to deduct your foreign taxes, you can fill out Form 1040 (Schedule A – Itemized Deductions). However, we recommend against this as it usually results in a lower reduction than the Foreign Tax Credit approach.
Once you know for a fact you want to utilize the Foreign Tax Credit, you can fill out Form 1116, or just use our online software to get it done smoothly! If you own a company abroad, you can use Form 1118 for Corporations.
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 personally?
- Did you pay 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?
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 the required minimum holding periods.
How Do the Foreign Tax Credit and Foreign Earned Income Exclusion Differ?
Two ways to avoid double taxation on the income you earn while living abroad are the foreign tax credit and the foreign earned income exclusion. A key difference is the income to which each applies. The foreign tax credit applies to both earned and unearned income, such as dividends and interest. Conversely, the foreign earned income exclusion applies only to earned income.
Foreign Tax Credit limitations rules for U.S. citizens abroad
There are a few foreign tax credit limitations for U.S. expats — you can’t just claim it on any income earned abroad. To claim the credit:
- The tax must be imposed on you
- You must have paid or accrued the tax
- The tax must be the legal and actual foreign tax liability
- The tax must be an income tax (or a tax in lieu of an income tax)
The tax must be imposed on you
If paying taxes to your resident country isn’t mandatory, you won’t qualify for the FTC. The tax must be imposed on you—for example, if you live in Australia and Australian taxes are automatically deducted from your paycheck, that is considered to be an income tax imposed on you.
You must have paid or accrued the foreign tax
You must have already paid or accrued the foreign tax. If you haven’t paid it, accrued it, or are not responsible for paying it, you won’t qualify.
The tax must be the legal and actual foreign tax liability
This is pretty self-explanatory. If you pay taxes to a foreign country, in order to use the FTC the tax must be a legal tax and you must be required to pay the tax. If, for example, you’re a digital nomad that has no current country of residence and thus no imposed income taxes, you wouldn’t be able to claim the FTC.
The tax must be an income tax
In order to claim the FTC, you must have paid income taxes to a foreign country. The IRS states the following types of foreign taxes are not eligible for the FTC:
- Taxes on excluded income (for example, if you’ve already used the foreign earned income exclusion)
- Taxes refundable to you
- Taxes paid to a foreign country deemed to support international terrorism
- Taxes for which you can only take an itemized deduction
- Taxes on foreign mineral income
- Taxes from international boycott operations
- A portion of taxes on combined foreign oil and gas income
- Taxes related to a foreign tax splitting event
- Social security taxes paid or accrued to a foreign country with which the United States has a social security agreement.
Be careful—the IRS has stipulations on what counts as a foreign “income” tax. For example, up until recently, foreign tax credit rules stated Americans living in France couldn’t claim a tax credit on French Generalized Social Contribution Taxes. Why? Because the IRS didn’t consider them income taxes. The IRS has since changed its stance and now U.S. expats in France may claim the FTC to offset these French taxes. Another example is the solidarity tax that supplements income taxes in Germany.
Some expats live in countries that do not have an income tax, like the UAE, but have other forms of taxes. If you paid foreign taxes in lieu of income taxes, you still may be able to offset them with the FTC. Taxes that qualify must be a foreign levy imposed in place of an income tax. Each scenario in each country is different, so we recommend you leave the Foreign Tax Credit limitations and rules to the experts.
What are the qualifications for claiming the foreign tax credit?
The IRS sets four specific conditions that any foreign income taxes must meet in order for you to be able to claim the foreign tax credit.
1. The tax must be imposed upon you
To qualify, you personally must be responsible for paying the tax. If you inherit a castle from a long-lost royal relative, for example, and estate tax is owed, that won’t count because it’ll be the estate that pays the tax and not you personally. But if you have income tax withheld from wages paid to you for pulling pints in that Irish pub, that would qualify.
2. You must have paid or accrued the tax
This one sounds a bit redundant after the first condition, but it basically means that you must have actually either paid the tax already or have an outstanding tax bill with the foreign government.
3. The tax must be the legal and actual foreign tax liability
The amount of tax you paid to the foreign government isn’t necessarily the amount of tax that will qualify for the credit. You’ll have to account for any refund you might have received for that tax. For example, if you get a refund from the foreign government for any of the foreign taxes that you’ve paid, you have to discount this amount from your foreign tax bill. For example, if you paid $1,000 in foreign taxes but the foreign government refunded $400 of that to you, you must exclude that refund amount when calculating your foreign tax credit, which would be $600 in this example.
4. The tax must be an income tax
You can claim a foreign tax credit for income taxes (and other taxes imposed as income taxes) that you’ve accrued or paid to a foreign government. Other types of foreign taxes don’t qualify.
One more important thing to note: Income you earn in certain countries won’t qualify for the credit — even if you meet other criteria.
Your income won’t qualify if the country where you earned it …
- Has been designated by the U.S. Secretary of State as repeatedly providing support for international terrorism (currently, North Korea, Iran, Sudan and Syria are designated as state sponsors of terrorism)
- Either doesn’t have diplomatic relations with the U.S. or has had its relationship severed by the U.S.
- Has a government that the U.S. doesn’t recognize (though there’s an exception if the country’s government is eligible to buy defense articles or services under the Arms Export Control Act).
How do I claim the foreign tax credit?
You’ll need to collect all the information about the foreign taxes you’ve paid to help you decide your best strategy going forward.
Forms you’ll need
In order to claim the foreign tax credit, you’ll typically need to fill out Form 1116. But you may not need to fill out the form if you meet all these conditions:
- If you earned passive foreign income only, such as interest or dividends from investments
- If all the income and any foreign taxes you paid on that income were reported on a “qualified payee statement” only, such as a Form 1099-INT, 1099-DIV or Schedule K-1
- If your total creditable foreign taxes aren’t more than $300 (or $600 if you’re married and filing jointly)
If you meet all three of these criteria, you can simply claim the foreign tax credit on line 48 of Schedule 3 without having to file Form 1116. If you’re able to claim the credit without filing Form 1116, you can use Credit Karma Tax®, a free online tax preparation and filing service, to do your federal income taxes and claim the foreign tax credit. If your amount of foreign taxes is more than $300 (or $600 if married filing jointly), you won’t be able to claim the credit using Credit Karma Tax® since it doesn’t support Form 1116.
Can you carry it forward?
The foreign tax credit is nonrefundable, so if you reduce your U.S. tax bill all the way down to zero and you still have some leftover credit, you can’t get the excess credit as a refund. But you may be able to carry the remaining unused credit forward for up to 10 years.
Tax carryovers allow you to claim an unused credit or excess portion of a used credit on a future tax return. You can also choose to file an amended return from the previous year as well, if you wish. But if you meet the criteria to skip using the Form 1116 and decide to claim the credit without it, you won’t be able to carry forward or carry back any unused credit.