Reducing the Foreign Tax Credit for Excluded Income

You can’t claim the foreign tax credit on income already excluded under the foreign earned income exclusion. You must reduce the credit. Here’s how.

Disclaimer: Please note that this guide is meant only as a general introduction to the foreign earned income exclusion and the foreign tax credit. Every situation is different and this guide does not cover several key details that may be needed for filing these forms or your US taxes accurately. Be sure to get help from a professional tax preparer who specializes in expat tax returns.

Using both the foreign earned income exclusion and the foreign tax credit together

If you are an expat who earns more than the maximum income that can be excluded under the foreign earned income exclusion, you still might be bale to avoid paying tax to the US.

If you also pay foreign income tax on foreign sourced income, you can maybe utilize both the foreign earned income exclusion and the foreign tax credit benefits together.

The catch is that you can’t claim the foreign tax credit on excluded income. This restriction requires that you reduce the amount of tax credit that you take according to a ratio of excluded income and non-excluded income.

There is a line on form 1116 to report by how much you must reduce the credit, but the form does not give you the calculation. You must go to the instructions for the formula calculation (found here on page 10, under line 12), figure out the amount, input the results, and attach a statement explaining the details.

Sometimes an expat should just claim the foreign tax credit to minimize US tax exposure, but in other cases it might be best to use them both together. Typically, a tax professional who specializes in expat taxes should look at both options for their clients and go with the best option.

Keep in mind also that there may be additional dynamics involved, such as claiming the foreign earned income exclusion so that it is not revoked for future years. This is why we suggest that you hire a professional.

Reduction of foreign tax credit – the formula

The first step is to create a fraction.

reducing the foreign tax credit for excluded incomeThe numerator is the foreign earned income exclusion plus the housing exclusion.

The denominator is generally the total earned income subject to foreign income tax, less deductions. Please see the instructions for more details.

Let’s look at a super simple example.

Let’s say that you earn and pay foreign income tax on $160, 000 and your total foreign earned income exclusion is $110,000.

The total foreign income tax, when converted to US Dollars, is $65,000.

You must reduce your foreign tax credit by $110,000 / $160,000 or by 0.6875.

Your foreign tax credit reduction amount is $65,000 * 0.6875 which equals $44,688. This amount is reported on form 1116 and the forms algorithm will only allow you to take a maximum foreign tax credit of $20,313.

You really should hire a professional

This example is only a general introduction to claiming both the foreign earned income exclusion and the foreign tax credit benefits together. The rules are a bit more complex than this and you should read the instructions to avoid preparation errors.

Things get much more complicated when considering different categories of income, different sources of income, and claiming the foreign housing exclusion.

Also, for the most part, only income taxes can be used for the foreign tax credit. There are different rules for wealth taxes, personal property taxes, real estate taxes, and social welfare taxes such as the non-US equivalents of Social Security and Medicare.

Then there are the considerations like the revocation of a previously made election to claim the foreign earned income exclusion.

For accuracy, support, and peace of mind, we strongly recommend that you hire a tax professional who specializes in US Expat taxes to prepare and file your taxes for you. Contact us here if you would like to hire us.

For a simple and complete guide to expat, click here.

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