The Foreign Tax Credit is a money-saving credit that the IRS offers to help offset the burden of double taxation. Check out below our step-by-step guide to filing Form 1116 for expats, and you’ll be saving money in no time!
What Is Form 1116: Foreign Tax Credit?
Expats complete Form 1116 to use the Foreign Tax Credit to reduce their US income tax liability, dollar for dollar. Before completing Form 1116 on your US expat taxes, you must meet four criteria:
- You must have a foreign tax liability that was either paid or accrued during the current tax year,
- The tax must be assessed on income,
- The tax must be imposed on you as an individual, and
- The tax must have originated legally in a foreign country.
Taxes that are due to be refunded to you are not included in the amount of foreign taxes paid. Before completing Form 1116, all of the foreign taxes paid will need to be converted to US dollars. The IRS prefers that each transaction be converted at the foreign exchange rate at the date of each transaction. These historical exchange rates can be obtained from oanda.com. If the number of transactions is excessive or the exchange rate is not readily available, they will accept the annual average foreign exchange rate. To support the preparation of your US expat taxes, the IRS provides average yearly exchange rates on their website. If the taxes have been assessed but have not yet been paid, you should use the exchange rate on the last day of the year for which the taxes were assessed.
Do I need to file Form 1116 to claim the foreign tax credit?
If you plan to use the foreign tax credit, you generally need to elect this by filing Form 1116 but there are some exceptions. You can use the foreign tax credit without Form 1116 if the following apply:
- Your only source of foreign income for the tax year is passive income
- Your qualified foreign taxes for the year are not more than 300 US dollars or 600 US dollars if you’re filing in joint return
- All of your gross foreign income and foreign taxes are reported to you on a payee statement such as a Form 1099, dividend or 1099 interest and then you elect this procedure for the tax year
Generally, this will only apply for people who have a very small amount of income that they’re paying foreign tax on. For instance, if you own some shares of a foreign corporation and you get a small dividend in the amount of $200 or something like that. The IRS doesn’t require that you file Form 1116 in those cases but you can still claim the foreign tax credit on the dividend or interest income that you earned on those assets.
Form 1116 Instructions
Step One: Find Out If You Qualify for the Foreign Tax Credit
Only four stipulations must be met before you can use the Foreign Tax Credit:
- You must have incurred or paid a foreign tax liability.
- 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.
Step Two: Know Your Options
You have two choices when it comes to the Foreign Tax Credit: you can deduct the taxes you’ve paid to your resident country on your Federal Tax Return, or you can fill out Form 1116 and take a credit that will reduce any amount that you owe the US, dollar for dollar. If the credited amount is more than you owe, you can carry that amount over and apply it toward any taxes you may owe in the next decade.
For US citizens who have lived abroad for extended periods, carrybacks and carryforwards of credits can be very important. If you are eligible for a foreign tax credit larger than your US expat income tax liability, the credit can be carried back to the tax year immediately preceding the current, or carried forward for the next ten years. This means that you can use the excess credit to try to obtain a refund from the prior year where you did not have enough credits to offset your US tax liability or choose to offset your future years’ tax liability. Most taxpayers will retain a schedule attached to their annual US tax return that includes all of the foreign tax carryovers for which they are eligible.
Step Three: Convert Your Taxes Into US Dollars
Next, you’ll need to convert the amount of taxes you paid to your resident country into US dollars using the exchange rate from the date of the transaction. Try Oanda.com’s currency converter! If that is too cumbersome, you can use the annual foreign exchange rate on the IRS website. Remember: if you accrued taxes but have not paid them, use the exchange rate from the last day of the applicable tax year.
Step Four: Identify the Limits
The amount of credit that you claim can’t be more than the amount of tax you pay on foreign earned income. You can use this formula to help determine the limit:
Foreign sourced taxable income divided by total taxable income before exemptions, multiplied by total US tax equals foreign sourced US tax
Other limits apply, too. For instance, some taxes can’t be claimed, such as taxes paid to a government that supports terrorism (as defined by the Secretary of State), taxes associated with financial services income, dividends from each 10-50 percent-owned foreign corporation, shipping and aircraft income, domestic international sales corporation dividends, dividends from foreign sales corporations, foreign trade income of foreign sales corporations, and foreign oil and gas extraction income.
Lastly, don’t forget that the Foreign Tax Credit cannot be used on income that has already been excluded by the Foreign Earned Income Exclusion.
Step Five: Complete Form 1116
At the very top of the form are some crucial instructions regarding income categories. A different Form 1116 will need to be completed for each category of income!
For most expats, the general category income may suffice, as it includes wages and business income. But if you have passive income, that necessitates an additional Form 1116, as do Section 951A income, foreign branch income, Section 901(j) income, lump-sum distributions, and certain income re-sourced by treaty.
Form 1116 Example
Let’s take for example the situation of Blake & Lauren Expat, Montana natives who moved abroad to become professional samba dancers.
In 2019, Blake & Lauren had an income of $65,000 and paid taxes to the Brazilian government in the amount of $15,000. They had a $3,000 foreign tax credit carryover from 2017 and a $4,000 carryover from 2018. Additionally, Blake & Lauren had $17,129 in itemized deductions, $10,550 of which were due to home mortgage interest.
Typically, all of their income would be excluded because of the Foreign Earned Income Exclusion, and Blake & Lauren would not have a US tax liability. However, for this example, we will assume that Blake & Lauren have not yet claimed the Foreign Earned Income Exclusion and will only be claiming the foreign tax credit.
When claiming the foreign tax credit on Form 1116, taxpayers are required to categorize the income earned by the taxpayer. A separate Form 1116 will need to be completed for each category of income. Luckily, Blake & Lauren only have income attributable to the General Income category (basic wage, salary & business income). For information regarding the other categories, please contact one of our US expat tax experts.
The information portion of Blake & Lauren’s Form 1116 will be completed as follows:
Form 1116: Part I
Next, Blake & Lauren will complete Part I. This information asks the taxpayer to explain all of the income from sources outside the US. Blake & Lauren only had income from Brazil, in the amount of US$65,000.
As US citizens, Blake & Lauren are required to report and pay taxes on this income to the US. However, they are still eligible for itemized or standard deductions, which they have used to offset their income. Before calculating their foreign tax credit, these amounts will need to be considered on their Form 1116.
Part I will be completed as follows:
Form 1116: Part II
Part II of Form 1116 asks the taxpayer to report the amount of taxes that were paid or accrued by the taxpayer in the current tax year.
Please note that this section also asks for foreign taxes paid to be reported in the foreign currency amount, as well as the US dollar amount. In Brazilian real, the amount of foreign taxes that Blake & Lauren paid was 8,161 R$.
When reporting this information, the IRS also requests that the taxpayer add a statement to the tax return that includes the foreign currency conversion rate.
Form 1116: Part III
Part III of Form 1116 computes the amount of credit eligible to be claimed on the taxpayer’s US tax return.
With earned income of $65,000, and claiming itemized deductions of $17,129, Blake & Lauren had a US tax liability of $5,039.
Each line of Part III is essentially calculations, and the instructions associated with each line on the form will walk the taxpayer through its completion.
The foreign tax credit for which Blake & Lauren are eligible will completely wipe out their US expat tax liability, and they never even had to complete the much more complex Form 2555! Nor did they have to tap into their prior year’s foreign tax credit carryovers.
Blake & Lauren paid $15,000 in total foreign taxes during 2019. However, because their US tax liability was only $5,039 after their exemptions and itemized deductions, they could only use $5,039 of the total $15,000. Thus, they will be eligible to carry $9,961 of the 2019 foreign tax credit over into future tax years!
Form 1116: Part IV
The last portion of Form 1116 asks the taxpayer to summarize the foreign tax credits claimed on other Forms 1116 for the current tax year. Because Blake & Lauren only had income from the “General” category, they will only need to include this one form, and Part IV of Form 1116 will be completed as follows:
Let Greenback Take Care of Your Form 1116
Although the IRS does require US citizens and Green Card-holders to report and pay taxes on their worldwide come, there are many ways to reduce double taxation, including the Foreign Tax Credit. See our series about how to reduce your tax liability as a US citizen for other examples of credits and deductions. Although this article offers a simple example of how to file Form 1116 for the Foreign Tax Credit, it may be too complicated for expatriates who need to file US expat taxes. If you need any assistance with your Form 1116, or if you would like to know more about our expat tax services, please contact us for expert help. The Greenback experts are ready to make your expat taxes easy. Get started with Greenback today!