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This article was fact-checked by our editors and reviewed by Troy Grimes, tax product specialist with Credit Karma Tax®.
Whether you’re pulling pints in a picturesque Irish town for the summer or working in the Hong Kong office of a large multinational corporation, working abroad can pose a tricky tax problem: double taxation on income you earn in a foreign country.
The foreign tax credit is designed to help address that issue.
When you’re a U.S. citizen working in a foreign country, you may owe income taxes to the U.S. and possibly to the country where you’re working. This means you could be taxed twice on the same income. Luckily, the IRS provides relief in the form of the foreign tax credit.
- What is the foreign tax credit?
- What are the qualifications for claiming the foreign tax credit?
- How much is the foreign tax credit worth?
- How do I claim the foreign tax credit?
The foreign tax credit is a nonrefundable credit that allows you to reduce the amount of tax you owe dollar for dollar when you file your U.S. tax return. It helps ensure you don’t pay income taxes twice on the income you earn while working abroad.
It’s not the only way the federal government helps taxpayers avoid double taxation on foreign income though.
There’s also a tax deduction for certain foreign taxes paid during a tax year. Like other deductions, the deduction for foreign tax reduces only the amount of your income subject to federal income tax, rather than directly reducing the amount you owe. You’ll have to itemize to take the deduction. And you can choose either the deduction or credit, but you can’t claim both.
You may also have the option of choosing the foreign earned income exclusion, which allows you to exclude a certain amount of foreign income from your taxable income. There’s also a provision for excluding eligible housing costs incurred in a foreign country.
But you can’t claim the foreign tax credit if you take either the foreign earned income or foreign housing exclusions. Since tax credits directly reduce your tax bill as opposed to your taxable income, the IRS says in most cases you’ll be better off claiming the foreign tax credit. If in doubt, run the numbers to find out which is the best method for you.
The IRS sets four specific conditions that any foreign income taxes must meet in order for you to be able to claim the foreign tax credit.
1. The tax must be imposed upon you
To qualify, you personally must be responsible for paying the tax. If you inherit a castle from a long-lost royal relative, for example, and estate tax is owed, that won’t count because it’ll be the estate that pays the tax and not you personally. But if you have income tax withheld from wages paid to you for pulling pints in that Irish pub, that would qualify.
2. You must have paid or accrued the tax
This one sounds a bit redundant after the first condition, but it basically means that you must have actually either paid the tax already or have an outstanding tax bill with the foreign government.
3. The tax must be the legal and actual foreign tax liability
The amount of tax you paid to the foreign government isn’t necessarily the amount of tax that will qualify for the credit. You’ll have to account for any refund you might have received for that tax. For example, if you get a refund from the foreign government for any of the foreign taxes that you’ve paid, you have to discount this amount from your foreign tax bill. For example, if you paid $1,000 in foreign taxes but the foreign government refunded $400 of that to you, you must exclude that refund amount when calculating your foreign tax credit, which would be $600 in this example.
4. The tax must be an income tax
You can claim a foreign tax credit for income taxes (and other taxes imposed as income taxes) that you’ve accrued or paid to a foreign government. Other types of foreign taxes don’t qualify.
One more important thing to note: Income you earn in certain countries won’t qualify for the credit — even if you meet other criteria.
Your income won’t qualify if the country where you earned it …
- Has been designated by the U.S. Secretary of State as repeatedly providing support for international terrorism (currently, North Korea, Iran, Sudan and Syria are designated as state sponsors of terrorism)
- Either doesn’t have diplomatic relations with the U.S. or has had its relationship severed by the U.S.
- Has a government that the U.S. doesn’t recognize (though there’s an exception if the country’s government is eligible to buy defense articles or services under the Arms Export Control Act)
You can use Form 1116 to calculate the amount of your foreign tax credit. This form walks you through two calculations.
- How much foreign income tax you’ve paid or accrued
- How much of your U.S. tax obligation can be attributed to your foreign income
Whichever of those two numbers is smaller is the amount of your foreign tax credit.
Let’s say you paid $3,000 in foreign income taxes while working as an interpreter abroad. If your total U.S. tax bill is $4,000 but half of that is from working abroad, then the U.S. income tax that’s attributable to your foreign income is just $2,000. In that case, $2,000 is the smaller of the two numbers, and that would be the amount of your tax credit.
You’ll need to collect all the information about the foreign taxes you’ve paid to help you decide your best strategy going forward.
Forms you’ll need
In order to claim the foreign tax credit, you’ll typically need to fill out Form 1116. But you may not need to fill out the form if you meet all these conditions:
- If you earned passive foreign income only, such as interest or dividends from investments
- If all the income and any foreign taxes you paid on that income were reported on a “qualified payee statement” only, such as a Form 1099-INT, 1099-DIV or Schedule K-1
- If your total creditable foreign taxes aren’t more than $300 (or $600 if you’re married and filing jointly)
If you meet all three of these criteria, you can simply claim the foreign tax credit on line 48 of Schedule 3 without having to file Form 1116. If you’re able to claim the credit without filing Form 1116, you can use Credit Karma Tax®, a free online tax preparation and filing service, to do your federal income taxes and claim the foreign tax credit. If your amount of foreign taxes is more than $300 (or $600 if married filing jointly), you won’t be able to claim the credit using Credit Karma Tax® since it doesn’t support Form 1116.
Can you carry it forward?
The foreign tax credit is nonrefundable, so if you reduce your U.S. tax bill all the way down to zero and you still have some leftover credit, you can’t get the excess credit as a refund. But you may be able to carry the remaining unused credit forward for up to 10 years.
Tax carryovers allow you to claim an unused credit or excess portion of a used credit on a future tax return. You can also choose to file an amended return from the previous year as well, if you wish. But if you meet the criteria to skip using the Form 1116 and decide to claim the credit without it, you won’t be able to carry forward or carry back any unused credit.
Working abroad can be an enlightening experience in many ways, including making you aware of how the tax systems of two different countries work. Managing your tax obligations to two countries can be a challenge, but at least Uncle Sam offers some relief from double taxation in the form of the foreign tax credit.
Dealing with foreign taxes can be complicated, so consider seeking advice from a qualified tax professional.
Troy Grimes is a tax product specialist with Credit Karma Tax®. He’s worked in tax, accounting and educational software development for nearly 30 years. He has a bachelor’s degree in business administration with an emphasis in business analysis from Texas A&M University. You can find him on LinkedIn.