What Is the Foreign Tax Credit?

What Is the Foreign Tax Credit?

Let me explain the foreign tax credit directly to you: it's a U.S. tax credit that offsets income tax you've paid abroad. If you're a U.S. citizen or resident alien who pays income taxes to a foreign country or U.S. possession, you can claim this credit. It reduces your U.S. tax liability and ensures you're not 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. You can claim it if you're a U.S. citizen or resident earning income abroad and have paid foreign income taxes. Foreign taxes on income, wages, dividends, interest, and royalties generally qualify for this credit.

How the Foreign Tax Credit Works

If you've paid taxes to a foreign country or U.S. possession and are subject to U.S. tax on the same income, you can take an itemized deduction or a credit for those taxes. Report the deduction on Schedule A of your 1040 or 1040-SR, which reduces your U.S. taxable income. If you choose the credit, it directly reduces your U.S. tax liability, and you must complete Form 1116 and attach it to your U.S. tax return.

You must take a credit or a deduction for all qualified foreign taxes—you can't mix them by taking the credit for some and a deduction for others, and you can't claim both for the same tax. Taking the credit usually makes more financial sense because it reduces your actual tax bill instead of just lowering your taxable income. This tax break eases the double tax burden that would otherwise hit you if taxed twice on the same income.

Generally, only income, war profits, and excess profits taxes are eligible for the credit, along with foreign taxes on wages, dividends, interest, and royalties. The IRS requires that the tax must be a levy not in payment for a specific economic benefit and similar to a U.S. income tax. You can also claim the credit on foreign taxes that aren't under a foreign income tax law if they're 'in lieu' of income, war profits, or excess profits tax, meaning they're imposed instead of an income tax the country otherwise applies.

Foreign tax is typically in a foreign currency, so use the exchange rate on the date you paid the foreign tax, it was withheld, or you made estimated tax payments. Other foreign taxes, like real and personal property taxes, don't qualify for the credit, but you may deduct them on Schedule A even if claiming the credit. You can deduct foreign real property taxes unrelated to your trade or business, but other taxes must be expenses from a trade or business.

Individuals, estates, and trusts can use this credit to reduce income tax liability. You can carry any unused foreign tax back one year and forward up to 10 years.

Do I Qualify for the Foreign Tax Credit?

Not all taxes paid to a foreign government qualify for a credit against your U.S. federal income tax. For the foreign tax to qualify, it must be imposed on you by a foreign country or U.S. possession, you must have paid or accrued it, it must be your legal and actual foreign tax liability for the year, and it must be an income tax or a tax in lieu of one.

There's a limit on the credit amount, calculated on Form 1116, and you claim the smaller of the foreign tax paid or your limit, unless you qualify for exemptions like having only passive foreign source income, qualified foreign taxes under $300 ($600 if married filing jointly), foreign income and taxes reported on forms like 1099-DIV or 1099-INT, and you elect this for the year. If you qualify, claim it directly on Form 1040.

Be aware: if you claim the foreign earned income exclusion or foreign housing exclusion, you can't take a foreign tax credit for taxes on excluded income. Doing so could lead the IRS to revoke your choices.

Refundable vs. Non-Refundable Tax Credits

Tax credits are either refundable or non-refundable. A refundable one gives you a refund if it exceeds your tax bill—for instance, a $3,400 refundable credit on a $3,000 bill gets you $400 back. A non-refundable credit only reduces your tax to zero, so with a $3,400 non-refundable credit on a $3,000 bill, you owe nothing but forfeit the extra $400. Most credits, including the foreign tax credit, are non-refundable.

What Is the Difference Between Tax Credits and Tax Deductions?

Tax credits reduce your tax owed dollar-for-dollar, while deductions lower your taxable income. Both save money, but credits are more valuable. A $1,000 credit cuts your bill by $1,000, whereas a $1,000 deduction in the 22% bracket saves you $220.

What is the Difference Between the Foreign Tax Credit and the Foreign Earned Income Exclusion?

To avoid double taxation on income earned abroad, you have the foreign tax credit and foreign earned income exclusion. The key difference is the income they apply to: the credit covers earned and unearned income like dividends and interest, while the exclusion only applies to earned income.

Who Can Claim the Foreign Tax Credit?

As a U.S. citizen, the U.S. taxes your worldwide income regardless of where you live. To avoid double taxation, you can claim a credit for foreign taxes paid or accrued. U.S. citizens and resident aliens who paid foreign income tax and are subject to U.S. tax on it can take the credit. Nonresident aliens can too if they were bona fide residents of Puerto Rico for the year or paid foreign taxes connected to a U.S. trade or business.

The Bottom Line

The foreign tax credit is a U.S. tax break offsetting income tax paid to other countries. To qualify, the tax must be imposed on you by a foreign country or U.S. possession, and you must have paid it. Taxes on income, wages, dividends, interest, and royalties generally qualify.