Q: Tax Playa, I really don't want to bother with the foreign earned income exclusion. Can I just take a tax credit for foreign income taxes paid?
Moyra, Alexandria VA
A: The foreign tax credit is sometimes a good option for people in higher-tax jurisdictions than the U.S. Knowing whether to claim the exclusion or the credit involves running the numbers both ways and seeing which one works better for you. The credit is also ideal for foreign unearned income like interest and dividends...
For more information on the foreign tax credit, consult IRS Publication 512, Foreign Tax Credit for Individuals.
For the purposes of this discussion, I will assume either of the following:
- You are not claiming the foreign earned income exclusion either because you have no foreign earned income or have chosen to waive the exclusion, or
- You have claimed the foreign earned income exclusion, and would like to use the foreign tax credit to offset double taxation on unearned income and earned income that could not be excluded.
U.S. citizens and resident aliens are liable to pay taxes on total worldwide income. This can create a double-taxation situation if another country also taxes the same income. The foreign tax credit is one way of making sure that as little money as possible is subject to double-taxation.
If you pay foreign taxes, you can choose either to deduct it as an itemized deduction, or take a credit for it. It is normally much more lucrative to take the credit.
Eligible taxes to deduct include foreign income taxes, foreign real estate taxes on a primary residence, and foreign taxes paid in connection with a trade or business. The only eligible tax for the foreign tax credit is foreign income tax.
Claiming the Credit
Claiming the credit involves filing a Form 1116. The only time this is not true is if the income in question is passive, has all been reported on 1099-INTs and 1099-DIVs, and the amount of the income is less than $300 ($600 if married filing jointly). In that case, the credit is simply written into the return.
The credit is limited to the product of your U.S. tax liability multiplied by the percentage of your income that is foreign. For instance, if you earned 40% of your income overseas and had U.S. tax of $10,000, the foreign tax credit for you cannot exceed $4000. To make this even more difficult, your various kinds of income must each individually apply this test.
For most people, the "baskets" of income break down into several categories:
- Passive income (dividends, interest, rents, royalties, non-business capital gains, annuities, etc.)
- General limitation income (earned income, virtually anything else).
Therefore, most people face about two foreign tax credit limits: their passive income tax times the percentage of their passive income that is foreign; and their other income tax times the percentage of their other income that is foreign.
If you have a foreign capital loss or foreign capital gain, the annual capital loss amount and the lower capital gains tax rates must be taken into effect. This is so complicated that I won't even try to explain it. Software is a must.
If the US has a tax treaty with a foreign nation, the rules there apply. In general, these treaties allow a good deal of income to avoid double-taxation.
Disallowed foreign tax credits (because of all the ratio-ing above) can be carried back for one year and forward for up to ten years. Carry-backs and carry-forwards that mix married filing jointly and other returns have to allocate properly between spouses.