As an expat, no matter where you live and work, your US and foreign income is subject to taxation. The fact that the majority of countries around the world also require you to file and pay tax locally makes the matter even more complex. To avoid double taxation, the US allows you to take a Foreign Tax Credit based on the foreign taxes you pay to your resident country. The Foreign Tax Credit is subtracted directly from your US income tax. However, if you cannot claim the full credit amount, you are allowed a carryover. Carryovers do expire, though, so read on to find out how best to utilize this credit!
How Is the Foreign Tax Credit Calculated?
Before we dive into the Foreign Tax Credit carryover, let’s review how to calculate the Foreign Tax Credit. First, you must allocate your Foreign Tax Credit into categories of income:
- Passive income includes investment income such as dividends, interest, and rent.
- General income includes all income not classified as passive. This category is typically inclusive of your salary or other earned income, but can also include foreign pensions, foreign unemployment, or other foreign types of pay not classified as passive income.
Once your income is allocated to each category, you can calculate the Foreign Tax Credit. You will have to make a separate calculation for each type of income.
The allowable credit for each category may be limited. You’ll calculate that limit by multiplying the total amount of US income tax liability by the percentage of taxable foreign income to total worldwide income. You need to perform this calculation to determine your percentage for each category.
George has earned $50,000 in salary (converted from UK pounds to US dollars) while living and working in the UK. George also earned $1,000 in interest (again, converted from UK pounds to US dollars) from his foreign bank account. George has some US investments that earned $5,000 in dividend income. George’s total taxable income is $56,000. George paid $15,000 in taxes to the UK on his salary and another $200 on his interest income, and the total US tax reported is $7,190.
Step 1: George must allocate his income to the categories of general or passive.
In his case, $50,000 of salary is allocated to the general category of income and $1,000 of interest is allocated to the passive category of income.
Step 2: Complete a Form 1116 for each category of income.
General category: $50,000 foreign income. The percentage is calculated by dividing the $50,000 foreign earned income by $56,000 in gross income from all sources, for a result of 89.29%. We must multiply the tax liability of $7,190 by 89.29% to arrive at the allowable Foreign Tax Credit of $6,420 for general income.
Passive category: $1,000 foreign interest. The percentage is calculated by dividing the $1,000 in foreign interest by $56,000 in gross income from all sources, for a result of 1.79%. We must multiply the tax liability of $7,190 by 1.79% to arrive at the allowable Foreign Tax Credit of $128 for passive income.
Step 3: Calculate the Foreign Tax Credit carryover.
General category: Of the $15,000 in Foreign Tax Credit available, George used $6,420. The difference of $8,580 is carried over. Passive category: Of the $200 in Foreign Tax Credit available, George used $128. The difference of $72 is carried over.
Step 4: Add the total Foreign Tax Credit to reduce US taxes.
Line 44: US tax liability $7,190
Line 48: Foreign Tax Credit $6,548
George still owes $642 in US tax. Even though George had Foreign Tax Credits and a US tax liability, he could only use the Foreign Tax Credit to offset the tax due on foreign income. He still owes tax on the $5,000 in US dividends.
What If Your Foreign Tax Credit Exceeds the Limit?
If your Foreign Tax Credit exceeds the IRS calculated limit for the year, you may carry the excess forward for up to 10 years. If you do not use the Foreign Tax Credit carryover in ten years, you lose the credit.
How Are the Foreign Tax Credits Applied?
If you have a Foreign Tax Credit carryover from a prior year as well as a current year Foreign Tax Credit, you must apply the current year tax credit first. The carryover can only be used after you have exhausted all of the current year credit.
What If I Continue to Accumulate Carryovers on My Foreign Income?
If you live and pay tax in a highly taxed foreign country, you will most likely continue to accumulate Foreign Tax Credit carryovers. If you were to move back to the US with a carryover credit, you could not use the credit against your US source income; it could only be applied to foreign income. This means the only way to use up carryover credit would be to move to a lower-taxed country.
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Editor’s Note: This blog was originally posted in 2017 but was updated on December 16, 2019.