Foreign Tax Credit (FTC) Limitation on Form 1116 For Americans

Simon Misiewicz

Expat & Property Tax Specialist

13th April 2022

What are the basics of Foreign Tax Credits? IRS Form 1116 limitation instructions

As property accountants serving thousands of UK landlords who purchase buy-to-let properties, we know that working through foreign tax credits is a complicated task for many clients.

The US Foreign Tax Credit (FTC) limitation on Form 1116 allows Americans who pay income taxes to claim US tax credits on a dollar-by-dollar basis to the same value as income taxes they have already paid to a foreign country.

The tax credit on foreign income reduces their US tax liability. The FTC may be claimed on the IRS 10409 tax return following the form 1116 instructions.

Some Americans in the US have foreign source income on which they may pay foreign income tax on.

These Americans can claim US tax credits up to the value of the foreign taxes paid to avoid double taxation.

It is worth looking at IRS guidelines on Foreign Tax Credits and the Form 116 instructions. One of the benefits of your FTC is that you have a carryover. This means that you can carryover the unused foreign tax credits to be used in your future IRS 1040 tax filings.

When can expats claim FTCs on form 1116 (instructions)?

FTC does not include a property tax in another country.

Expats can claim the Foreign Tax Credit if they have paid foreign income taxes on non-US source income. Take needs to be taken. We recommend following the IRS guidance and instructions very carefully.

Foreign income taxes are legally imposed and must be paid.

Expats with income that meet these criteria can use the Foreign Tax Credit to claim US tax credits to the dollar value of the foreign income taxes paid.

Expats who live abroad but are paid by a US company into a US bank account may have their wages taxed at source. These wages may still be liable to foreign income taxes. These expats may have to claim tax credits in the foreign country where they live to avoid double taxation.

They may be able to exclude this income from US taxation by claiming the Foreign Earned Income Exclusion.

Expats with US and foreign source income may have to file one tax return paying the total tax rate. They may have to file a return to benefit from the tax credits. Finally, they may need to file an amended version of the first return to claim the other tax credits.

This allows evidence of taxes paid to be provided to both countries when claiming the tax credit on the respective incomes.

We recommend reading these Foreign Tax Credit compliance tips from the IRS. If you need to know more, please visit the IRS form 1116 instructions page. Make sure you read up on Foreign Tax Credits and the carryover of unused credits. This can help you save tax in the short and long term.

How can expats reduce their US tax bill?

Not all expats can or should claim Foreign Tax Credits.

Some expats either live in a low-taxed country compared to the US or move between countries without establishing tax residence in any single one.

These expats may not be required to file foreign taxes at all.

If expats pay foreign income tax at a lower rate than the US whilst claiming Foreign Tax Credits, this won’t eradicate their US tax liability. They can only claim US tax credits based on the value of foreign income taxes paid. They may have to pay some US tax as well.

Expats such as Digital Nomads who don’t pay foreign taxes as they move from country to country without establishing tax residency don’t charge US income taxes. They won’t be able to claim the Foreign Tax Credit.

IRS provisions exist to help these expats reduce their US tax bills, notably the Foreign Earned Income Exclusion.

The Foreign Earned Income Exclusion allow American expats to exclude the first circa $112,000 (2022) of their earned income from US taxation.

The exact amount is increased annually based on inflation.

Earned income includes all income that is paid for services provided, such as salaries, wages, self-employment income, tips and bonuses.

It does not include passive income such as dividends, interest, rental or pension income, social security benefits, capital gains or alimony payments.

The Foreign Tax Credit doesn’t distinguish between earned and unearned income so long as foreign income taxes have been paid. You are advised to read the IRS instructions and policies on both the Foreign Tax Credit (FTC) and Foreign Earned Income Exclusion (FEIE) very carefully.

To claim the Foreign Earned Income Exclusion, expats must also demonstrate that they meet one of two IRS definitions of living abroad.

The first is that they spend at least 330 full days in 365 days outside of the US, called the Physical Presence Test.

The second test is whether they are a permanent resident in another country. This is called the Bona Fide Residence Test.

Expats earning over $112,000 and renting their home abroad can also exclude a proportion of their housing expenses by claiming the Foreign Housing Exclusion.

It is called the Foreign Housing Deduction for self-employed expats.

Expats who live in a single foreign country and pay foreign income taxes at a higher rate than the US rate on all of their global income are best off claiming the Foreign Tax Credit.

Expats who don’t pay foreign taxes or who pay them at a lower rate, whose only income is earned and doesn’t exceed over $112,000 and who can meet either the Physical Presence Test or the Bona Fide Residence Test are better off claiming the Foreign Earned Income Exclusion.

We also recommend that you utilise US and UK tax treaty instructions and guidance if you live in the UK as an American expat.

How do I claim FTCs?

To claim Foreign Tax Credits, expats must file their foreign tax returns and pay foreign taxes first.

The IRS acknowledges that this may not be possible before 15th April. This is particularly if they live in countries with a different tax year, such as the UK, which has a tax year from 6th of April to April of 5th.

Expats have an automatic IRS filing extension to 15th June and can claim an additional extension online to 15th October.

IRS Form 1116 is a two-page form that requests the information and figures necessary to calculate what value of US tax credits can be claimed based on foreign taxes paid.

It requires American expats to provide details about which country their foreign taxes were paid in. The IRS wants to know the value of foreign taxes paid (in foreign currency and US dollars). In addition, the IRS wants to know the types of income the taxes were paid on and any foreign deductions and expenses.

Who is eligible for Foreign Tax Credit? What are FTC limitations?

You are eligible for Foreign Tax Credit if you’re a US citizen or resident who earns foreign income abroad and paid taxes to your country of residence.

Amerian Expats will often owe no US tax when working in a country with a higher tax rate than the US, such as China. The tax rules depend on the country you earn money in and the foreign tax credit limitations.

There are limitations for US expats claiming foreign tax credits, including:

* The tax must be imposed on you

* You must have paid or accrued the tax

* The tax must be the legal and actual foreign tax liability

* The tax must be an income tax

It is also worth noting that you won’t qualify for the FTC if paying taxes to your resident country isn’t mandatory.

The IRS states the following types of foreign taxes are not eligible for foreign tax credits:

* Taxes on excluded income (for example, if you’ve already used the Foreign Earned Income Exclusion)

* Taxes refundable to you

* Taxes paid to a foreign country deemed to support international terrorism

* Taxes for which you can only take an itemised deduction

* Taxes on foreign mineral income

* Taxes from international boycott operations

* Taxes related to a foreign tax-splitting event

* A portion of taxes on combined foreign oil and gas income

* Social security taxes paid or accrued to a foreign country in which the US has a social security agreement

The IRS has stipulations on what counts as a foreign income tax.

Some American expats living abroad do not have an income tax, like the UAE but have other forms of taxes.

If you paid foreign taxes instead of income taxes, you might still be able to offset them by claiming foreign tax credits. Do not worry if you are not able to utilise all the tax credits. There is a carryover scheme that allows you to reduce future tax bills.

What is a carryover?

Your unused amount can carry over to the next tax year or carry back to the previous year if you don’t use the full tax credit amount allowed.

If you were short on tax credits in the previous year, your leftover amount must be carried back.

Example: You have a $500 carryover amount in the previous year. You were short $600 in credits on foreign income. Instead of carrying it forward, you must carry back that $500 from that year earlier.

Your foreign tax credit can carry over for up to 10 years.

To get the maximum credit amount, you’ll divide your foreign-sourced taxable income by your total taxable income, and then multiply that result by your US tax liability.

Example: You’re a US citizen who moved to Germany for a teaching job. You have a salary of $60,000  and paid $26,400 in taxes to the German government.

You also have $10,000 in US trust income. At the end of the year, you have a US tax liability of $16,000.

To calculate your allowable foreign tax credit amount, you’d take:

$60,000 (foreign-sourced taxable income)

Divided by

$70,000 (your total taxable income)

= .86

You’d then take that .86 and multiply it by your US tax liability ($16,000) = $13,760.

You could receive up to $13,760 as an FTC.

The difference between $26,400 (German taxes paid) and $13,760 is your Foreign Tax Credit carryover amount.

FTC vs the Foreign Earned Income Exclusion

Foreign Tax Credits (FTC) are not the only tool to offset US taxes for expats.

The Foreign Earned Income Exclusion (FEIE) lets you deduct foreign income from your yearly tax filing like any other deduction.

The FTC is different because it lets you claim a dollar-for-dollar tax credit to reimburse you for taxes already paid to your host country.

A significant difference between the FTC and FEIE is what counts as income.

The FEIE only applies to income from your wages.

The FTC applies to gross income from all sources, including passive income like interest or dividends.

However, it only works if you pay taxes to the country you now reside in.

Factors to consider when choosing between the FTC and FEIE include:

* Your income type and source

* Your housing expenses

* Your future plans for life and work abroad

* Your dependents and their US citizen status

* Whether you pass the Physical Residence Test or the Bona Fide Residency Test

* Your current country of residence and their tax laws

* Your foreign tax liability to your country of residence

We recommend you review the information on Foreign Tax Credit vs the Foreign Earned Income Exclusion for further guidance.

Form 1116, concerning the foreign tax credit (FTC) limitation, is an essential document for U.S. taxpayers with foreign income. This form allows them to claim a credit for income taxes paid or accrued to a foreign country, mitigating the double taxation burden. It requires detailed information about foreign-sourced income and the taxes paid on it. The credit is limited to the lesser of the actual foreign taxes paid or the U.S. tax liability on the foreign income, ensuring that taxpayers don't receive more credit than they're entitled to. Understanding Form 1116 is crucial for those navigating the complexities of international taxation and seeking to optimize their tax obligations efficiently.

What is Form 1116 and who needs to file it?

: Form 1116 is used by U.S. taxpayers to claim a foreign tax credit against their U.S. tax liability. It's typically filed by individuals who have paid or accrued tax to a foreign country on income that's also subject to U.S. taxation.

How does the foreign tax credit limitation work on Form 1116?

The foreign tax credit is limited to the lesser of the amount of foreign tax paid or accrued, or the U.S. tax liability on the foreign income. This prevents taxpayers from claiming more in credits than they owe in U.S. taxes on their foreign income.

Can the Form 1116 be used for all types of foreign taxes?

Form 1116 is generally used for income taxes paid to a foreign government. It does not apply to taxes such as VAT, sales taxes, luxury taxes, or property taxes.

What happens if my foreign tax exceeds the credit limit on Form 1116?

If the foreign tax paid is higher than the credit limit, the excess can usually be carried back one year and then carried forward for up to ten years, potentially offsetting U.S. tax in those years.

Are there any special considerations for filing Form 1116 for specific countries or types of income?

: Yes, there are specific rules and considerations depending on the country and the type of foreign income. For instance, there are different categories for passive income, general income, and certain types of income like royalties or dividends. Tax treaties between the U.S. and specific countries can also affect how you file Form 1116.

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