Most Americans keep their finances close to home, earning money in the U.S. and investing largely in U.S.-based assets. However, those who earn foreign income might find themselves having to pay taxes to foreign governments. Although paying taxes is never ideal, you might be able to claim a foreign tax credit for at least some of the taxes that you have to pay abroad.
How the foreign tax credit works
The general idea behind the foreign tax credit is to give you a chance to avoid getting taxed twice on the same income. If you paid foreign taxes to a foreign country and are also subject to U.S. tax on the same income, then you can typically get a foreign tax credit. The amount of the credit is typically the smaller of the tax that the U.S. imposes on the income and the foreign tax that you've paid. So if you earned income in a jurisdiction where taxes are higher than in the U.S., then your credit will be less than the foreign tax amount you paid. On the other hand, if you earned income in a low-tax jurisdiction, then you'll typically get the full amount of foreign tax back in the credit.
The foreign tax credit most often comes up in a couple of common situations. First, if you work abroad and pay foreign taxes, then you might qualify for the credit. Second, if you own foreign investments that generate investment income on which you pay tax -- or of which the foreign country automatically withholds a portion -- then a foreign tax credit may also be available to you.
How to claim the foreign tax credit
Most taxpayers have to file IRS Form 1116 in order to calculate and claim the foreign tax credit. The form will require you to state the amount of income subject to tax in each foreign country, along with the amount of tax paid. You'll then calculate whether the foreign tax or the U.S. tax is higher and claim the credit accordingly. In addition, foreign taxes paid must be reported on common tax forms like 1099s or Schedule K-1 statements.
In some cases, you won't have to file IRS Form 1116. If your total creditable foreign taxes are $300 or less for single filers or $600 or less for joint filers, then you don't have to file Form 1116 if all of the income came from interest, dividends, or other passive category income. For instance, if your only source of foreign income is in exchange-traded funds or mutual funds, then you'll typically be able to take the credit on your 1040 return without filing Form 1116 so long as the amounts don't exceed the appropriate limit.
When foreign workers don't get the credit
If you work abroad, it's important to understand how the foreign tax credit works with other tax breaks. In particular, the foreign earned income exclusion allows you to exclude up to $102,100 in income earned abroad during 2017 from U.S. tax. An exclusion for foreign housing provided by your employer also applies. If the foreign government in your place of business makes you pay tax on your foreign earned income, then you can't claim a foreign tax credit -- precisely because the U.S. didn't charge you any tax on that income. In other words, because there's no double taxation, the money that was subject to exclusion from U.S. tax doesn't need the foreign tax credit in order to be taxed at a fair level.
However, if you earn money above the income limit, then the excess can be eligible for the foreign tax credit. Again, IRS Form 1116 will be able to run you through the calculations to determine the proper amount of credit to which you're entitled.
The foreign tax credit can be somewhat complicated, but it can also save you a lot in taxes if you're eligible. If you have income from abroad and have paid tax on it, then it's worth looking into the foreign tax credit to see if you can get some of your hard-earned money back.