Get to know the authorIf you’re an American citizen that lives overseas, then you need to know about IRS Form 1116. It’s the form that helps you claim the Foreign Tax Credit (FTC), which can save you from having to pay taxes both in your new home country and the US.
Don’t forget that the US has a citizenship-based taxation system. That means that all US expats, regardless of where they live, have to declare their worldwide income. Yep, you heard that right. Not only do they have to pay taxes within their new home country but also to good ol’ Uncle Sam.
In this blog post, you’ll learn everything you need to know about Form 1116 to claim your foreign tax credits and reduce your tax liability.
What Is the Foreign Tax Credit (FTC)?
The IRS has a program called the Foreign Tax Credit (FTC), which helps US expats eliminate double taxation and save money on US taxes. It’s an especially helpful program for American expats that live in countries with a higher income tax rate than the US.
With the FTC, American citizens who pay foreign income taxes within their new country can claim US tax credits on a dollar-for-dollar basis, not to exceed the US tax rate (meaning the foreign tax credit won’t ever result in a refund). The FTC assigns the credits to the same value of taxes they’ve already paid overseas. As a result, US expats can avoid double taxation and reduce their US tax liability.
Who’s Eligible for the Foreign Tax Credit (FTC)?
US expats must meet certain criteria before they can claim the benefits of the Foreign Tax Credit (FTC). American expats must be able to prove that they’re paying taxes on their foreign earned income in their new country of residence.
The IRS will assess these three tests to determine if your income overseas qualifies for the Foreign Tax Credit:
- – Your new home country imposed the tax on you. You can’t qualify for the FTC if your new home country doesn’t require residents to pay income tax. For example, if you live in France and your employer automatically deducts taxes from your paycheck, that counts as imposed taxes.
- – The tax must be legal within your new home country. You can only benefit from the FTC if you paid legal taxes. For example, if you spent six months in Portugal (a popular spot for digital nomads) but paid no imposed tax while you were there, you don’t qualify for the FTC.
- – The tax you paid needs to be income tax. The IRS only accepts income taxes paid in a foreign country to qualify expats for the FTC. Below, you’ll find a list of foreign taxes that the IRS doesn’t accept.
Once your taxes paid fit the three requirements above, then you can claim the FTC. However, taxes that aren’t eligible for the FTC include:
- – Sales tax
- – Social security taxes
- – Real estate taxes paid on a foreign property
- – Taxes on mineral, gas, or oil income
- – Taxes to a country sanctioned by the US government
To learn more about if the income in your new country qualifies for Foreign Tax Credit, contact a trusted tax advisor to offer guidance on your situation.
What Is Form 1116?
To claim your foreign tax credit on your tax return as a U.S citizen, you’ll need to use Form 1116. According to the IRS official website, you can use 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.”
On Form 1116, you must convert all of your foreign earned income into US dollars. You’ll have to go through the IRS’ yearly exchange rates for the foreign currency that pays you to calculate this.
Form 1116 consists of four different sections:
- – Part 1: In this section, taxpayers will have to declare all of their sources of income outside the US.
- – Part 2: The taxpayer will have to report all of the foreign taxes they paid throughout the year.
- – Part 3: You must calculate your FTC credit eligibility based on your income category.
- – Part 4: This section is where US taxpayers will have to summarize all FTC credits from each category.
How Are Foreign Tax Credits on Form 1116 Calculated?
To calculate the limit on your foreign tax credits, you’ll have to take your foreign taxable income and divide it by your total taxable income. Once you do this calculation, you then multiply it by your total US tax obligation. The final number is the limit on how much you can claim in foreign tax credits.
Let’s dive into a basic example. You live in the Netherlands and earn $70,000. You already paid $25,000 in foreign taxes to the Dutch government. On top of that, you make an extra $15,000 from rental U.S income each tax year.
The IRS tells you that you owe $16,000 in US income taxes.
$70,000 (foreign taxable income) / $85,000 (total taxable income) = .82
Next, we use that number and multiply it by our US tax obligation. This calculates the number of foreign tax credits we can claim:
.82 X $16,000 = $13,120
In total, you can claim up to $13,120 worth of foreign tax credits. What’s also great is that if you don’t use the total amount of your foreign tax credits, you can “carry over” that unused amount to the next tax year.
How Much Foreign Tax Credit Can I Claim with Form 1116?
There’s a limit to the number of foreign tax credits you can claim. You cannot claim more foreign tax credits than the amount you’re already paying in foreign earned income.
If you don’t want to bother doing all the math to determine how much you can claim in foreign tax credits, you can always let a tax advisor handle the calculation.
Can You Claim Foreign Tax Credit without Form 1116?
Depending on your situation as an American expat, you may not have to file Form 1116 to claim the Foreign Tax Credit.
For example, let’s say that all your foreign-earned income is passive income. In this case, filing Form 1116 won’t be necessary due to ineligibility.
If you’re an expat in a US territory such as the Virgin Islands, you’ll also have different instructions when it comes to filing Form 1116. With earnings less than $300 per person (or $600 per couple) in foreign taxes, you won’t have to file Form 1116 to claim your foreign tax credit either or file the US tax return altogether.
Are There Penalties if I Don’t File Form 1116?
No, there are no penalties if you don’t file Form 1116. That said, if you don’t file Form 1116, you’ll lose dollar-for-dollar credits that you could use to reduce your US tax liability. So why not take advantage of the extra savings on taxes?
Form 1116 vs. Form 2555: What’s the Best Option?
Some US expats wonder whether it’s better to file Form 2555, the form to claim the Foreign Earned Income Exclusion (FEIE), to reduce their tax liability. The FEIE allows US expats to exclude a portion of their foreign income from their US tax liability. While both forms help eliminate double taxation for US expats, they are not the same.
What makes the FEIE different from the FTC is the types of income it can be applied to are different. Unlike the FTC, FEIE only applies to income from wages. That means that the FEIE doesn’t cover other forms of income, such as passive income from dividends.
If you’re still unsure which program better fits your need, contact a US tax advisor to guide you through the process.
Let Bright!Tax Help You File Form 1116
There are a lot of complex calculations that go into filing Form 1116. You have to determine first if you’re eligible for the Foreign Tax Credit, calculate how many credits you can claim based on how much you earn…it can seem like you have to go through various loops and holes before you can finally benefit from the credit.
This is why Bright!Tax saves US expats stress from filing their tax returns – by handling all required paperwork. Our tax professionals have helped Americans across 200 countries comply with their IRS obligations with total peace of mind.
You can get started today! Simply share with us some brief information about your current expat tax situation. Shortly after, one of our CPAs will then be in touch to guide you through the next steps.
