The Foreign Tax Credit is a money-saving credit that the IRS offers to help offset the burden of double taxation. In order to claim this credit, you’ll have to fill out Form 1116, a two-page form that comes with a 24-page set of instructions from the IRS. Check out below our step-by-step guide to filing Form 1116 for expats, and you’ll be saving money in no time!
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. Neat!
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.
Check out this example of Form 1116 for a visual walk-through of the calculation of the credit.
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