As a US expat, you’re probably aware that the US requires you to pay taxes on your worldwide income – and it’s one of few places in the world that do so. Fortunately, certain credits and deductions are available to help offset the potential amount owed. One of these is the Foreign Tax Credit, also known as Form 1116, which allows you to take a credit for your foreign earned income. Here are the details you should know.
The Foreign Tax Credit Explained
The Foreign Tax Credit is a dollar-for-dollar reduction of your US tax liability on your foreign earned income. Note that you can’t take the credit against the income you’ve already excluded with the Foreign Earned Income Exclusion (FEIE).
To claim the Foreign Tax Credit on your US expat taxes, you’ll need to meet the following four criteria:
- You must have a foreign tax liability that was 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.
Any taxes that are due to be refunded to you are not included in the amount of foreign taxes paid. To claim the credit, you’ll need to complete Form 1116 and attach it with your Form 1040 (Federal Tax Return). To fill out Form 1116, first, you must convert your foreign taxes paid into US dollars. Typically, the IRS would like to see each transaction converted at the foreign exchange rate at the date of the transaction, which you can obtain from a site like oanda.com. If you have difficulty finding specific exchange rates or have an excessive number of transactions, the IRS will also accept the annual average foreign exchange rate. If you have taxes imposed but not yet paid, you should use the exchange rate on the last day of the year for which the taxes are assessed.
How to Calculate the Foreign Tax Credit
The amount of credit you claim on your US expat taxes cannot exceed the amount of US tax that you pay on foreign earned income. To determine the amount of the limitation, use this formula:
Foreign Sourced Taxable Income/Total Taxable Income Before Exemptions * Total US Tax = Foreign Sourced US Tax
Foreign source taxable income (FSTI) is all income earned in a foreign country, including interest from foreign banks, dividends from foreign corporations, and rental income from foreign properties. You’ll want to remove deductions that are directly related to this income before calculating the final FSTI. If your income is earned both in and out of the US, you should allocate the income based on the days worked in the US and days worked in the foreign country.
Limitations on the Foreign Tax Credit
You’ll find that some foreign taxes aren’t eligible for the credit – including taxes paid to certain countries that the Secretary of State has designated as supporting international terrorism, like Iraq and North Korea, for example. Other taxes that can’t be claimed include those 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. Despite the fact these can’t be claimed toward the Foreign Tax Credit, know that they can be claimed as an itemized deduction on Schedule A.
If you’re eligible for the Foreign Tax Credit, and it’s larger than your US expat tax liability, you’re able to carry the credit back to the tax year immediately preceding the current, or you can carry it forward for the next ten years. This means you could use the excess credit to try to obtain a refund for the prior year or choose to offset your future years’ tax liability. Many taxpayers retain a schedule attached to their Federal Tax Return that includes the details of any carryforwards they are eligible for.
For US citizens who have lived abroad for long periods, these carrybacks and carryforwards can be quite substantial!
Filling Out Form 1116
When you are claiming the Foreign Tax Credit, you must categorize the income earned, which means you must use a separate Form 1116 for each income category. The general income category is the most common and includes basic wage, salary, and business income.
- Part I – This is where you’ll explain all of your foreign earned income. You’ll also include itemized and standard deductions here to offset the income earned.
- Part II – This is where you’ll report the amount of taxes that were paid (or accrued) in the current tax year. This section asks you to report foreign taxes paid in the foreign currency amount as well as the US dollar amount. You’ll also need to add a statement to the tax return that includes the foreign currency conversion rate.
- Part III – This is the section that computes the amount of the credit you’re eligible to claim on your US expat taxes. Each line has calculations, and the instructions will walk you through the completion of each line.
- Part IV – This is where you’ll summarize the Foreign Tax Credit claimed on other Forms 1116 for the current tax year. If you only had income from the General category as mentioned above, you’ll only include the information from this single form.
Have Questions About the Foreign Tax Credit and How It Can Help You Save?
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Originally published in 2016. Updated on November 20, 2019.