Foreign Tax Credit Relief for U.S. Expats – More than Meets the Eye
One of the main challenges facing expat tax filers is ensuring they can avoid the double taxation of their income – that is, taxation of their income by both the local taxing authority and the IRS. For many expats, the more obvious way to accomplish this is to utilize the foreign earned income exclusion (the “FEIE”). While the FEIE is a powerful tool for avoiding double taxation, there are times when it may not actually be the best choice for the U.S. expat tax filer.
In fact, there are instances when foreign tax credit relief is the superior choice for expats looking to reduce or eliminate double taxation.
In this blog, we review the basics of foreign tax credit relief and run through a couple of scenarios where the foreign tax credit is the superior strategy.
Foreign Tax Credits – The Basics
Foreign taxes eligible for foreign tax credit relief under the US tax system 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 amount of foreign tax credits that may be taken is limited to the amount of foreign source taxable income and cannot be used to offset U.S. source income.
The employee portion of foreign social security taxes in certain countries can be considered a foreign income tax available for the foreign tax credit. However, social security taxes are not creditable if paid to a country with which the United States has a so-called totalization agreement (for example, the UK and Australia).
Aside from specific situations, in order to claim a foreign tax credit, an individual must file Form 1116 with their U.S. federal income tax return.
Foreign Tax Credit Relief for Parents
When comparing foreign tax credit relief to the foreign earned income exclusion, the clear winner for expat parents is most often the foreign tax credit.
Taxpayers who utilize the FEIE cannot claim the additional child tax credit (the portion of the credit that exceeds your tax liability), which is now refundable up to $1,400 per child. This limitation does not apply, however, when the foreign tax credit is utilized.
Thus, assuming that your creditable foreign tax exceeds your U.S. tax, reducing your tax via foreign tax credit relief is the smarter choice.
Foreign Tax Credit Relief for Retirement Savings
Foreign tax credit relief can also provide the better strategy in the case that a U.S. expat who maintains a US retirement account, such as a traditional or Roth IRA. That is because income that is excluded as a result of the FEIE is considered income that cannot be contributed to an IRA.
For this reason, US expats looking to save for retirement might find that foreign tax credit relief might yield more advantageous results than the FEIE. If you claim the foreign tax credit, you’ll have taxable wages to fund the IRA in the United States.
Takeaway for U.S. Expats
While this blog describes certain scenarios where foreign tax credit relief may be the preferred strategy, it is important to keep in mind that not all circumstances are alike.
Sensitivity to the nuances of the U.S. tax rules is essential for optimizing your U.S. tax return filing.
By Joshua Ashman, CPA & Nathan Mintz, Esq.