For US Expats, the foreign tax credit is often the best option for reducing taxes when living and working abroad. Here’s why.
Disclaimer: This guide is simple and is meant only as a general introduction. It does not replace the need to carefully review the IRS publications to see which is the best and most accurate way to file. Please consult with a tax professional or go over all of the rules very carefully. There are many complex scenarios to where the foreign tax credit may or may not be the best option for expat taxpayers.
Introduction to the foreign tax credit for US Expats
To put it simply, US Expats living abroad can claim a tax credit for income taxes paid to most foreign countries. The idea behind the credit is to prevent the double taxation of US Citizens and permanent residents.
Note that there are a few “rouge” or “enemy” countries on a list to where the IRS will not allow the credit.
The foreign tax credit form (Form 1116) is designed so the taxpayer will pay no more in total tax to the country of residence plus the United States than as if they had domestic income sourced only from the United States. In many cases, but not all, the tax credit will be dollar for dollar, which might eliminate all income tax liability owed to the US on foreign sourced income.
For example, a taxpayer earns $50,000 of wage income in France and pays $24,000 of income taxes to France. If the tax owed in the US on this income is $16,000, then the taxpayer will not owe tax to the United States.
In another example, a taxpayer earns $50,000 of wages in Singapore and pays $12,000 in income taxes to Singapore in that year. Again the tax that would normally be owed to the United States is $16,000. In this case, the taxpayer will owe $4,000 to the United States.
In either case the taxpayer did not pay more than a total of $16,000 of tax to both countries in total and was not double taxed when compared to the US Tax rates.
Please note that the foreign tax credit formula is not so cut and dry. The above examples are oversimplifications.
The outcome of the total credit may change based on many computed factors including other credits, income amounts, exclusions, and certain deductions. You must go line by line of the form to compute the exact amount of credit because in many cases the credit will not be so simply “dollar for dollar”.
In summary, expats living and working in countries with relatively high income tax rates (like most European Countries) will benefit the most form this credit. For those paying taxes to countries with low income tax rates, they might face some additional taxes due to the United Sates. Either way, the taxpayer will not pay more than as if they were simply in the US working and paying US taxes.
Foreign tax credit vs the foreign earned income exclusion
There are a few exceptions, but as a tax professional, I usually choose the foreign tax credit over the foreign earned income exclusion when there is enough income tax paid to eliminate all US tax liability.
This is because the FTC is much more straight forward and “black and white” than the exclusion. It is also more flexible, as the exclusion election is considered revoked if it is not claimed in a year for which it was available and then it can’t be claimed for five years (with exceptions).
If a taxpayer has been claiming the foreign earned income exclusion, and they qualify to claim it in a current year, it probably makes sense to claim it again instead (or in addition to) the foreign tax credit. This is to prevent the exclusion election from being revoked.
Also, if a US taxpayer is living abroad in a low income tax country, and has no plans to “skip around” then it often makes sense to claim the exclusion. This is an area where you should really hire a tax professional to go over the entire situation and figure out what is best for you and your individual situation.
The foreign tax credit in conjunction with the foreign earned income exclusion
In some cases, it may make sense to claim both the FTC and the exclusion together. It is important to note that the foreign tax credit must be reduced in ratio to the amount of income that is excluded, as you can’t take the credit on excluded income.
There is a formula in the instructions explaining how to allocate the percentage and reduce the foreign tax credit accordingly.
Unused foreign tax credit can generally be carried over
In most cases, any excess or unused foreign tax credit in a given year can be carried over in full to following years.
This is helpful because many other countries use a fiscal year instead of a calendar year and the tax payments may not line up so well for the taxpayer.
With the use of a carryover, an excess in one year can be “kept in the taxpayers back pocket” to be pulled out in a future year that contains a tax payment deficit. The application of carryover foreign tax credit is complex, and we recommend that you seek help from a professional if you have foreign tax credit carryovers.
Accrued vs paid taxes and the foreign tax credit
Another great area of relief allowed within the foreign tax credit is the ability for the taxpayer to use either:
1) The amount of tax actually paid out of pocket during the year or
2) The amount of tax “accrued” for the tax year that was either paid in advanced or in following years.
Accrued basically means that these were the amounts that accumulated during the year.
Generally,once a taxpayer elects to use the accrual method, they can’t switch back to the actual method without specific IRS permission.
Conversion to US dollars
Foreign taxes are almost always paid to non US countries in a non-US currency. The IRS provides a table of average exchange rates that they use as a suggestion. US Taxpayers do not have to use these tables, but they must use a reasonable computation, it must be used consistently, and it must hold up to substantiation in an examination.
The foreign tax credit provides credit for a specific character of income
Each taxpayer must fill out Form 1116 for EACH income type and claim the credit accordingly.
In other words, if a US Taxpayers has $200,000 US Dollars in capital gains and paid $40,000 of capital gains tax to a foreign country, the taxpayer can only apply the $40,000 towards credit against capital gains reported on his or her US tax return.
You can’t use $20,000 of it toward capital gains and then apply the remaining $20,000 toward tax on wages and/or interest income, for example.
Foreign taxes paid on capital gains can only be used in the US toward capital gains tax. The same goes for passive income like interest income, and the same goes for wages.
You can’t mix and match.
This includes carryover taxes too. You can’t take a carryover on unused tax credit based on wage income and use it to offset new taxes from dividend income, for example.
The foreign tax credit does not include certain taxes
Not all types of taxes can be offset by the FTC as it is generally only for taxes based on income.
Many non-US countries impose a tax based on the value of personal and business property. This is often referred to as a “wealth” tax. You can’t claim a US credit for foreign wealth taxes.
Another typical tax that are not credited are social taxes, like those similar to self employment tax, social security, and medicare taxes.
There are many more exceptions as to what types of taxes can be claimed and in what situations they can be claimed. Please research the instructions and IRS publications carefully.