With the expat tax deadline quickly approaching, you may be wondering how you can save the most money possible when you file your American expat taxes. There are two primary tools to help Americans living abroad save on their expat taxes, one being the Foreign Tax Credit. Here are the details you should know to determine if the Foreign Tax Credit is the best choice for you.
Understanding the Foreign Tax Credit
The Foreign Tax Credit (FTC) is a dollar-for-dollar reduction of your US tax liability on the income you earned in a foreign country. It can be used alone to offset your American expat taxes, and it’s especially useful in countries with a higher tax rate. You can also use it in conjunction with the Foreign Earned Income Exclusion (FEIE), but note that it can only be used on foreign income in excess of the FEIE’s exclusion amount – which is currently $101,300 for your 2016 US Tax Return.
Using the Foreign Tax Credit
There are a few requirements you should be aware of in order to use the FTC on your expatriate tax return. To claim the FTC, you must meet the following criteria:
- You must have a foreign tax liability paid or incurred.
- 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.
You must complete Form 1116 (learn more about completing this form here) and attach it with your American expat taxes in order to use the FTC. You will need to convert your foreign taxes paid into US dollars. In most cases, the IRS prefers to see each transaction converted at the foreign exchange rate on the transaction date (you can use a site like oanda.com for a helpful conversion tool). However, if you have difficulty finding specific exchange rates or have an excessively high number of transactions, you can also use an annual average foreign exchange rate, which can be found on the IRS website.
Calculating the Foreign Tax Credit
So, you’ve determined you qualify – now you’re probably wondering how the FTC is calculated. First, you should know that the FTC you claim on your American expat taxes can’t exceed the amount of US tax paid on foreign earned income. Here’s the formula you’ll need to use to determine the amount of the limitation:
Foreign Sourced Taxable Income/Total Taxable Income Before Exemptions * Total US Tax = Foreign Sourced US Tax
Your foreign source taxable income is all income earned in a foreign country, and it also includes:
- Interest from foreign banks
- Dividends from foreign corporations
- Rental income from foreign properties
You will need to remove deductions that are directly related to this income before you calculate your final foreign source taxable income.
Carrying Your FTC Forward or Back
If you are able to reduce your taxable income to zero with the FTC and still have credit left over, you have the option to either carry forward or carry back the remaining amount.
If you had a hefty tax liability the prior year, you can carry it back and file an amended return. Or, you can hold on to the credit and apply it in future years (you have up to 10 years to use it) to help cover any shortages.
The details of the Foreign Tax Credit can certainly be confusing, so we recommend discussing your individual situation with an expat tax professional to ensure you save as much as possible on your American expat taxes. For more money-saving tips, download our guide to expat taxes.
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