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!