IRS Pub 514: Foreign Tax Credit for Individuals

U.S. taxpayers who earn income from foreign sources may be subject to taxation on that income in both the foreign country and the United States. To alleviate this double taxation, the foreign tax credit allows individuals to offset the U.S. income tax they owe by the amount of income taxes already paid to a foreign country. The foreign tax credit is non-refundable, meaning it can reduce a taxpayer’s U.S. income tax liability to zero, but no portion of the credit will be paid out as a refund. The rules governing this credit are specific, and IRS Publication 514 provides detailed guidance for taxpayers to determine their eligibility and correctly claim it.

Who Can Take the Credit and What Taxes Qualify

Eligibility to claim the foreign tax credit extends to U.S. citizens and resident aliens who have paid or accrued qualifying foreign taxes for which they are legally liable. The credit is not available for taxes paid on behalf of another person. To be creditable, a foreign levy must be an income tax in the U.S. sense or a tax paid in lieu of a generally imposed foreign income tax. Qualifying taxes include foreign income, war profits, and excess profits taxes, which must be compulsory payments and not for a specific economic benefit.

Conversely, many foreign taxes do not qualify for the credit, including:

• Value-added taxes (VAT)
• Sales taxes
• Property taxes
• Customs duties

While these non-qualifying taxes are not creditable, some may be deductible as a business expense or an itemized deduction. Additionally, taxes paid to certain foreign countries may not be creditable, as the U.S. government maintains a list of countries for which the credit is denied.

Deciding Between a Credit and a Deduction

Taxpayers with qualifying foreign income taxes must choose annually to either claim the taxes as a credit or take them as an itemized deduction. This decision applies to all qualified foreign taxes for that year; a taxpayer cannot deduct some and take a credit for others in the same year. A tax credit provides a dollar-for-dollar reduction of your U.S. income tax liability, so a $1,000 credit reduces your tax by $1,000. A deduction reduces your taxable income, so its value depends on your marginal tax bracket; a $1,000 deduction for someone in the 24% bracket saves $240 in tax.

For most individuals, claiming the credit is more advantageous because it directly reduces the tax owed. A deduction is less beneficial unless the foreign tax credit is subject to a limitation that severely restricts the amount that can be claimed. If a taxpayer later determines the other option was more beneficial, they can change their election. A taxpayer who originally claimed a deduction can amend their return to claim a credit within 10 years from the original due date, while one who claimed a credit can change to a deduction within the standard three-year amendment period.

Information and Forms Needed to Claim the Credit

To claim the foreign tax credit, taxpayers must generally use Form 1116, “Foreign Tax Credit (Individual, Estate, or Trust).” This requires identifying the foreign countries where taxes were paid and categorizing all foreign source income into the appropriate “baskets,” such as passive or general category income. Taxpayers must also have records of the foreign taxes paid or accrued, including the date and amount in the foreign currency. For filing, these amounts must be translated into U.S. dollars using the average exchange rate for the year or the rate on the date the tax was paid. Form 1116 is divided into parts for reporting foreign source income, detailing foreign taxes paid, and calculating the final credit.

An exception allows some taxpayers to claim the credit without filing Form 1116. This is available if all foreign source income is passive, the total creditable foreign taxes are not more than $300 ($600 for married filing jointly), and all foreign income and taxes are reported on a qualified payee statement like Form 1099-DIV. If these conditions are met, the credit can be claimed directly on Form 1040.

The Foreign Tax Credit Limitation Explained

A central concept of the foreign tax credit is the limitation, which prevents taxpayers from using it to reduce U.S. tax on U.S. source income. The allowable credit is capped at the lesser of the actual foreign income tax paid or the U.S. tax liability on that foreign income. This ensures the credit only offsets the U.S. tax that would have been due on income earned abroad. The calculation must be performed separately for the different categories of foreign income, or “baskets,” established on the form. The primary categories include passive category income and general category income, which covers most other types of earned income like wages and business profits.

The formula for the limitation is a ratio applied to the taxpayer’s U.S. tax liability: (Foreign Source Taxable Income in a Specific Category / Total Taxable Income from All Sources) x U.S. Tax Before Credits. For example, a taxpayer with $20,000 in foreign source income and $100,000 in total taxable income would have a limitation of $3,000 if their pre-credit U.S. tax was $15,000. In this case, even if they paid $4,000 in foreign income taxes, their credit would be limited to $3,000.

Filing and Managing Unused Credits

Once Form 1116 is completed, it must be attached to the taxpayer’s annual U.S. income tax return, Form 1040. The calculated credit amount is entered on Schedule 3 (Form 1040) and then flows to the main form to reduce the total tax liability. It is common for creditable foreign taxes to exceed the credit limitation for a given year. When this occurs, the excess credits are not lost but can be carried forward for up to ten years to be used in a future tax year, subject to that year’s limitation. Taxpayers must maintain proper records to track the amount of any unused credit, the year it originated, and its income category to ensure it is used before the ten-year period expires.