Americans overseas are always looking for ways to save money on their US tax returns. While many are familiar with the Foreign Earned Income Exclusion, the Foreign Tax Credit is another important tax credit that expats may be able to take advantage of, depending on their personal situation. Let’s take a closer look at the Foreign Tax Credit and how it may help offset a portion of your US taxes.
What is the Foreign Tax Credit?
The Foreign Tax Credit is a potential dollar-for-dollar credit on the taxes you pay to a foreign country. This is extremely helpful to expats living in cities with a higher tax rate, such as China or the United Kingdom.
How does it work?
You can use the Foreign Tax Credit all on its own and just use this credit to offset your taxes. It can also be used it in conjunction with the Foreign Earned Income Exclusion (FEIE). The FEIE allows you exclude up to the first $99,200 of your income from US taxation. But what if your income exceeds that? Then it’s time to look at the Foreign Tax Credit for help!
Requirements for using the Foreign Tax Credit
There are a few conditions that must be satisfied before you use this credit. You must:
- Have foreign income
- Have paid tax or incurred a tax liability
- Be living there legally
How can it help you save?
Let’s take a look at an example that will clarify how the Foreign Tax Credit can be used:
Mark is employed in the United Kingdom and has been living there for the past 3 years. He earned $200,000 (USD) this year and is getting ready to prepare his US taxes. After completing his HMRC Self-Assessment tax return, he notes that he paid $55,000 in income taxes to the UK. When he files his US tax return, he will report the full $200,000 on line 7 of form 1040, he will also file Form 2555 to elect the FEIE and exclude $99,200 (for 2014) of his income. The remaining income, $100,800, is now taxable. However, it is taxable at the top tax bracket rates of the $200,000 income, not the $100,800. Here’s where the Foreign Tax Credit comes into play. Markshows US tax of $25,000 on the $100,800 of income, but he’s already paid $55,000 in taxes to the UK. The $55,000 is first reduced proportionately to the income that was excluded: $99,200/$200,000 = 49.6% reduction. So, $27,720 ( $55,000 x 50.4%) in foreign taxes paid is available for the credit. Mark can use this amount to reduce his US income tax liability to zero. The remaining foreign taxes paid of $2,720 ($27,720 – $25,000) can be carried forward to the next tax year for future use.
The Carry Forward / Back
As mentioned above, if you aren’t able to use all of your foreign tax credits (i.e. you still had ones left over after completely reducing your income to $0) then you have options as to what you want to do with those leftovers. If you had a significant tax liability the previous year, you can carry back the tax credits to last year and file an amended return. Or, you could choose to hang on to those credits and apply it in the years moving forward if you need to cover a shortage. You have up to 10 years to use your credits. If you don’t use them during that period of time, they simply vanish.
One caveat: You cannot use the Foreign Tax Credit against income that has already been excluded. Taking the example from above, you could only use tax credits against the taxes owed on the $100,800 of income that was not excluded already. This is despite the fact that the $100,800 is taxed at the rate of the $200,000. Confused yet? We understand. If you have specific questions about how the Foreign Tax Credit can help you, please contact one of our expert CPAs or IRS Enrolled Agents today.
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If so, you may find more helpful information in this article, as it provides greater detail about exactly how the Foreign Tax Credit is calculated.