The foreign tax credit reduces your US tax by the foreign income tax you paid on the same income, so the same income is not fully taxed twice. It is claimed on Form 1116, which works the credit out separately for each category of income and limits it to the US tax on that income. Unused credit is not lost. It carries back one year and forward ten.
Credit or deduction
Foreign income tax can be claimed either as a credit or as an itemized deduction, but not both in the same year.
Almost always, the credit is better. A credit reduces the tax itself, dollar for dollar. A deduction only reduces taxable income, and only if you itemize. The deduction helps only in unusual situations, which are worth checking but should not be the default.
When you do not need the form
If all of your foreign income is passive, mostly interest and dividends, all of it is reported to you on a statement such as a 1099, and your total foreign tax is 300 dollars or less, or 600 dollars on a joint return, you can claim the credit directly on your return without Form 1116.
This is common for someone whose only foreign tax is withheld on dividends from an international fund. The trade off is that no carryover arises in a year this election is used.
How the form works
Form 1116 does not simply let you subtract foreign tax from US tax. It limits the credit to the US tax on the foreign income, and it does that separately for each category of income.
The two categories most people meet are:
- Passive: interest, dividends, rents and royalties that are not from an active business, and most investment gains.
- General: wages, business income, and most other active income.
Each category gets its own form. Foreign tax paid on salary cannot be used to offset US tax on foreign interest, and the reverse.
For each category, the form takes the foreign income, subtracts the expenses and deductions allocated to it, and works out what share of your total income it is. That share of your US tax is the most you can claim for that category.
What goes wrong on the form
The two errors we see most often are both about matching.
Income in the wrong category. Putting a salary in the passive category, or investment income in the general one, changes the limit on both. Often the credit looks fine in the year it is claimed and the carryovers are wrong in every year after.
Foreign tax claimed on income that is not in US income. The credit is for tax on income that the US is also taxing. Tax paid abroad on income that was excluded from US income, for example under the foreign earned income exclusion, cannot be credited. Nor can an amount that the foreign country will refund.
The tax has to be an income tax that you legally owed and actually paid. A foreign sales tax, a property tax, or a refundable withholding does not qualify.
Unused credit carries to other years
People often do not know that credit they cannot use this year is not lost. Unused foreign tax is carried back one year and forward ten years, within the same category.
That makes it worth tracking. A year when foreign tax exceeds the US tax on that income produces a carryover that may be worth a lot in a later year, but only if someone records it and uses it. A new preparer who does not have the history cannot claim it.
Where it fits
The credit is usually the most important part of a first resident return with income from abroad. Why that income is taxable at all is covered in foreign income after you become a US resident, and a treaty can change the answer for some income, as set out in tax treaties: how a treaty position is actually claimed.
Preparing the credit, and keeping the carryovers accurate from year to year, is part of the international service.