Form 1116 – An Introduction
As an alternative to (and for higher income earners, in complement to) the foreign earned income exclusion and foreign housing exclusion/deduction, a U.S. expat can claim a foreign tax credit (“FTC”) for foreign income taxes paid. The FTC reduces your actual U.S. federal income tax on a dollar for dollar basis.
Like the FEIE, the purpose of the foreign tax credit is to reduce the potential double tax burden that may otherwise arise when your foreign source income is taxed by both the United States and the foreign country in which you are resident.
Aside from specific situations, in order to claim the foreign tax credit, an individual must file Form 1116 with their U.S. federal tax return.
Which foreign taxes are eligible for the credit?
Foreign taxes eligible for the foreign tax credit are generally limited to income taxes imposed by a foreign country. It is important to note that often certain foreign taxes may appear as income taxes but will not qualify as income taxes for purposes of taking the foreign tax credit. For instance, foreign real estate taxes, sales taxes, luxury taxes, turnover taxes, value-added taxes, and wealth taxes, are generally not creditable.
The employee portion of foreign social security taxes is generally considered a foreign income tax available for the foreign tax credit. Social security taxes are not creditable, however, if paid to a country with which the United States has a so-called totalization agreement.
Who can claim the foreign tax credit?
In general, you can file Form 1116 to claim the foreign tax credit if:
- You are an individual, estate, or trust; and
- You paid or accrued certain foreign taxes to a foreign country or U.S. possession
You do not have to meet the bona fide residence or physical presence tests (as required for the foreign earned income exclusion) in order to claim the foreign tax credit.
How is the foreign tax credit calculated?
Your foreign tax credit is the amount of foreign tax you paid or accrued during the tax year. The foreign tax credit can be limited by the so-called “foreign tax credit limitation,” under which your foreign tax credit cannot be more than your total U.S. tax liability multiplied by a fraction. The numerator of the fraction is your taxable income from sources outside the United States, while the denominator is your total taxable income from U.S. and foreign sources.
If the foreign taxes available for credit exceed your foreign tax credit limitation, you may be able to carry the credit back to the previous tax year and forward to the next 10 tax years.
It is important to keep in mind that the foreign tax credit needs to be calculated both for regular tax purposes and for Alternative Minimum Tax (AMT) purposes.
What is the due date of Form 1116?
Form 1116 must be filed with your tax return in order to claim the foreign tax credit. Separate Forms 1116 are filed if you have multiple categories of income.