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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 IRS Form 1116, and you’ll be saving money in no time!
Form 1116 is used to claim the Foreign Tax Credit to reduce your US income tax liability, dollar for dollar. Before completing Form 1116 on your taxes, you must meet the four following criteria:
Note that 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.
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.
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:
Generally, this will only apply to 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 of less than $300. 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.
Only four stipulations must be met before you can use the Foreign Tax Credit:
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, then the credit can be carried back to the tax year immediately preceding the current or carried forward for the next 10 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.
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. If that process is too complex, you can use the annual foreign exchange rate on the IRS website.
If you accrued taxes but have not paid them, use the exchange rate from the last day of the applicable tax year.
The amount of credit you claim on your US 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 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:
Don’t forget that Form 1116 (Foreign Tax Credit) cannot be used on income that has already been excluded by the Foreign Earned Income Exclusion.
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.
Let’s take, for example, the situation of Blake and Lauren Expat, Montana natives who moved abroad to become professional samba dancers. In 2021, Blake and 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 2019 and a $4,000 carryover from 2020. Additionally, Blake and 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 and Lauren would not have a US tax liability. However, for this example, we will assume that Blake and 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 and Lauren only have income attributable to the General Income category (basic wage, salary, and business income). For information regarding the other categories, please contact one of our US expat tax experts.
The information portion of Blake and Lauren’s Form 1116 will be completed as follows:
Next, Blake and Lauren will complete Part I. This information asks the taxpayer to explain all of the income from sources outside the US.
Blake and Lauren only had income from Brazil, in the amount of $65,000 USD. As US citizens, Blake and Lauren are required to report and pay taxes on this income to the US. However, they are still eligible for itemized or standard deductions, which they have used to offset their income. Before calculating their foreign tax credit, these amounts will need to be considered on their Form 1116. Part I will be completed as follows:
Part II of Form 1116 asks the taxpayer to report the amount of taxes that were paid or accrued by the taxpayer in the current tax year. Please note that this section also asks for foreign taxes paid to be reported in the foreign currency amount, as well as the US dollar amount.
In Brazilian real, the amount of foreign taxes that Blake and Lauren paid was 8,161 R$. 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.
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 and 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 and 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 and Lauren paid $15,000 in total foreign taxes during 2021. 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!
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 and 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:
Although the IRS does require US citizens and resident aliens 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 taxes.