As you know, the United States requires all citizens and permanent residents (Green Card holders) to report worldwide income. You need to file annual income tax return regardless of where in the world you earned the money. As the name suggests, the Foreign Tax Credit for individuals reduces your U.S. tax burden on income that was earned and consequently taxed in a foreign country. In this way, you will not be subject to double taxation on that money.
Foreign earned income (FEI), dividends, interest, and even rental income that come from foreign sources are eligible for consideration with the Foreign Tax Credit. As long as a foreign entity imposed taxes on them and you paid! One benefit to using this credit is that it is available to all U.S. taxpayers who have foreign earned income or investment income from a foreign source. There are no stipulations regarding residency or time spent in a foreign country to take advantage of this reduction in taxes owed at home.
Don’t miss out on our free tax resources for U.S. taxpayers abroad! Free e-guides, checklists and a tool to check Foreign Earned Income Exclusion eligibility.
Form 1116: What is the catch?
Although Form 1116 is a great benefit, there are some limitations to this tax credit that you should be aware of.
- The money earned needs to be subject to income tax in the foreign country. Unfortunately, you cannot use the credit to offset the cost of the property or other taxes paid abroad. Income only!
- The credit can be up to the amount you paid the foreign country. However, it is limited to no more than the percentage of your income that was earned overseas. So if you only earned 40% of your income in a foreign country that was subject to taxation abroad, then you cannot take a deduction equal to more than 40% of your U.S. tax burden.
Let’s take a look at expat example using Foreign Tax Credit
Mark and Sylvia have been living and working in Spain for three years. They are full-time residents and earn all of their foreign earned income through the Spanish companies they work for (perhaps, you can relate to this example of how to claim the Foreign Tax Credit):
- As such, they are subject to the Spanish progressive tax rate of up to 52%. Yikes!
- Additionally, they have investment income in the U.S. that is 43% of their total income.
- By using the Foreign Tax Credit, they can deduct the amount they need to pay in U.S. taxes by subtracting the amount paid to the Spanish government.
- Since 57% of their income comes from a taxable foreign source, of the taxes paid to Spain from they can deduct up to that percentage from the total amount owed to the U.S., thus substantially reducing their tax burden.
Another fact: Sometimes, you will be taxed at a lower rate due to a tax treaty between the U.S. and the foreign entity. In this case, you can only claim the reduced tax for the U.S. Foreign Tax Credit. Of course, you are welcome to ask for a refund from the foreign country for the difference in the amount allowed.
So what about carryover on U.S. expat taxes?
The big advantage is an unused FTC from prior years automatically carries forward and you can utilize it in future years. For those who choose to take the tax credit, it may be that the taxes paid to exceed the credit limit for that year. In many cases, you can carry over the excess to the next tax year or even back to previous years.
The Foreign Earned Income Exclusion (FEIE) is another popular deduction in expat circles. With a limit of just over $100,000, it is possible that this could be used to reduce your tax burden as well. If you would like to learn more about the differences between the Foreign Tax Credit and the Foreign Earned Income Exclusion, we suggest you take a look at this handy infographic we prepared for you, which compares the two options.
Is the Foreign Tax Credit right for U.S. citizens living overseas?
In the end, every case is unique and a qualified tax professional can advise you on how best to proceed. The Foreign Tax Credit could likely be an important part of your tax plan for this year, but it is not the only option available to people who earn income outside of the United States. The most important thing to remember is that you should never ignore your U.S. tax filings, even if you find all of these acronyms (FTI, FEIE, FTC) and exceptions confusing. We are always here to help.
Do you still have questions? Let’s chat!
My wife and I will be moving from the U.S. (New Hampshire) to Spain toward the end of the this year, and we need to find an expert on Spanish foreign tax credit that can prepare and file our U.S. tax returns in the future. Do you have time for a phone conversation to discuss our questions and needs?
Thanks in advance.
Ryan Bliss
603.521.4736 Mobile
Hi Ryan,
We emailed you, please, check your inbox. Thanks!
I’m 3 years behind. Can I e-file my 2019 return now and follow up with paper returns for 2018/2017 (Unless I can efile those as well) I’m self employed in Canada with no US income for 2017/2018
Hi Angela! Yes, you can e-file 2019 and 2018. 2017 will have to be filed on paper.
I just rolled over a contribution to a new IRA from pension. I want to make the max contribution this tax year but usually claim the FEIE. I am near the bottom of the progressive tax brackets, making around 55k. My question is a) if I take the foreign income tax exclusion next year will it be enough to cover all my federal income tax? And B) what is the benefit of an ira over eta or mutual fund in my case? Thanks a lot!
Hi Justin,
After the FEIE, your standard deduction of $12,000 remains intact and can offset any other kind of income.
All the best,
Olivier