Foreign Tax Credit: Form 1116 Instructions
If you’re a US expat working and living abroad, you need to know about the Foreign Tax Credit for a couple of reasons.
Firstly, tax credits are more valuable than tax deductions. Credits offset the amount of tax you owe dollar for dollar. Deductions, on the other hand, reduce your taxable income.
Secondly, the US is one of only two countries that levies taxes based on citizenship – not your residence. This makes your worldwide income subject to US tax.
The effect is that you may find yourself paying taxes both in your country of residence and in the United States.
But, thanks to the US Foreign Tax Credit and tax treaties, you can offset the taxes you’ve paid or accrued in your country of residence against your US income tax bill.
And, of course, the IRS has a form for that. You claim the Foreign Tax Credit (FTC) using Form 1116.
Read more: How to claim the Foreign Tax Credit
In this article, we’ll walk you through the instructions for filling out Form 1116.
Step 1: Categorize your income
Since the IRS requires you to use a separate Form 1116 for each income category, you must categorize your income so you can know how many Forms 1116 to use.
For example, if your total income falls into three categories, you’ll need to use three separate Forms 1116.
Here are the income categories for IRS Form 1116.
As you can see, there are seven income categories. That means you can have up to seven Forms 1116.
🛑 But just a minute. If you’re like any typical expat working as an employee or running your own small business, you’ll likely only use one form for the “general category income.”
Once you’ve identified your income category, it’ll be time to move on to the next section.
Step 2: Fill in your taxable income (Part 1 of Form 1116)
Here’s where you’ll record all your income from foreign sources. If you’ve paid taxes in more than one foreign country, you’ll need to separate the earnings by country and enter them into different columns.
Form 1116 provides three columns. But if you paid taxes in more than three countries, you’ll attach a separate sheet laid out in the same manner as Part 1. There’s no need to use an additional Form 1116.
And when filling in your income details, there are a couple of things to remember…
- 📣 Include all your foreign income—even if all or some portion is not taxable by a foreign government.
- 📣 Income needs to be reported in US Dollars.
- 📣 You’ll need to adjust gross income (line 1a) for any foreign income that you’ve excluded with the Foreign Earned Income Exclusion, on Form 2555.
Then aside from your income, you’ll also input the amount of deductions usually used by the IRS to reduce your taxable income. This may be the standard deduction or itemized deductions for those with enough qualifying expenses.
These deductions include home mortgage interest as well as losses from foreign sources.
Here’s what this section of the form looks like.
Step 3: List your foreign taxes paid (Part 2 of Form 1116)
Here’s where you’ll list the amount of foreign tax you either paid or accrued in the current tax year on your income reported in Part 1. And (important callout) you’ll need to report it in the foreign currency and the US dollar equivalent.
For the conversion rate you use, you’ll need to include a statement to let the IRS know how you made the calculation.
Here’s what Part 2 of Form 1116 looks like.
Step 4: Calculate your credit amount (Part 3 of Form 1116)
This is where you’ll calculate the amount of FTC to claim. Generally, the amount of your credit is not the tax you paid in your country of residence. Instead, it’s the amount of tax you’d have paid if the income was earned and taxed according to the US tax code.
Let’s try to simplify this.
1️⃣ Suppose you work in Italy and earn an annual salary of $100,000 (US dollar equivalent) in 2022. And you paid $25,000 (US dollar equivalent) to the Italian tax authorities.
However, when your salary ($100,000) is subjected to the US tax code, it will be treated like it was earned in the US. You’ll still generally be allowed to claim all the tax deductions you’re used to, whether it’s the standard deduction or itemizing.
2️⃣ Let’s say your total deductions are $15,000. Therefore, your taxable income will be $85,000 ($100,000 – $15,000).
3️⃣ Finally, assume the tax payable on $85,000 in the US is $13,000. This is the amount that’ll be treated as your Foreign Tax Credit, NOT the $25,000 you paid in Italy.
|US Tax Deductions||($15,000)|
|US Taxable Income||$85,000|
|Foreign Tax Credit||$13,000|
But here’s the good news. Since you paid more tax than you’ve been allowed to claim in the current year, you CAN carry forward the difference up to a maximum of ten years.
Alternatively, you can carry it back to the prior year in certain situations.
Read more: How to calculate your FTC
Here’s what this section of Form 1116 looks like using our hypothetical example from above.
Step 5: Add up your total credit (Part 4 of Form 1116)
Finally, this is the last part, and a summary of all the foreign tax credits claimed in case you had other categories of income that we discussed in Step 1.
Here’s what it looks like.
🎉 That’s it!
If you have one source of income, filling out Form 1116 may not be difficult.
But if you have several sources and are confused about what falls where—we can help. Chat with one of our friendly, expert expat CPAs today, so you’ll not have to worry whether you’re doing it correctly.