How the Foreign Tax Credit Limitation Works (and When It Matters Most)

Most expats learn about the Foreign Tax Credit the way you learn about fire alarms: startled and slightly annoyed. The promise sounds comforting: if you paid income tax to another country, you may be able to claim a credit so you’re not taxed twice on the same foreign-source income.

And that’s often true—until you hit the part nobody mentions at dinner parties: the Foreign Tax Credit limitation. It caps how much credit you can use to the U.S. tax tied to your foreign-source slice, which is why the credit sometimes doesn’t cover what you expected.

If you want fewer nasty surprises and more “oh, that’s why,” this is the rule to understand before you file.

Who can claim (and who can’t)

The Foreign Tax Credit is meant to help U.S. taxpayers avoid double taxation. But it’s not a “paid some tax abroad, therefore free” coupon. Think of it as a guardrail: it helps, but it has limits.

You can usually claim it if…

• You’re a U.S. citizen or resident alien (and you’re reporting worldwide income on a U.S. return).
• You paid or accrued foreign income taxes to a foreign country (including a city/province, etc.).
• The tax was imposed on you (meaning you’re the one legally on the hook, even if it was withheld from wages).
• The tax relates to income included in your U.S. taxable income for the tax year (earned income, self-employment income, passive income like dividends/interest, capital gains, rental income, etc.).

Note: you generally report everything in USD, so you’ll be converting amounts using an exchange rate that makes sense for how/when the tax was paid.

You can’t claim it for…

• VAT/GST, sales/consumption taxes (they’re not income taxes).
• Social security/payroll-style taxes, and similar contributions.
• Penalties, interest, fines, and other “extras” tacked onto a tax bill.
• Foreign tax tied to income you excluded from your U.S. return (classic example: foreign tax on income excluded under the Foreign Earned Income Exclusion).

One more twist: treaties can change the shape of the puzzle.

Tax treaties don’t erase the FTC rules, but they can change how income is treated for FTC purposes (including “certain income re-sourced by treaty” categories on Form 1116).

And if the limitation prevents you from using all your foreign taxes paid this year, that unused amount may become a Foreign Tax Credit carryover to another tax year (instead of disappearing into the void like your patience).

What counts as foreign-source income

Here’s the mildly annoying truth: “foreign-source” doesn’t mean “money that showed up in a non-U.S. bank account.” It’s a tax law label that affects your U.S. tax liability by controlling how much Foreign Tax Credit you’re allowed to claim. And yes, this is why sourcing matters so much on Form 1116.

In broad strokes, the IRS sorts your types of income like this:

• Salary / wages: Usually sourced to where you physically do the work. So even if a U.S. employer pays you, work performed in a foreign country can produce foreign-source income.
• Self-employment / business income (including a foreign branch): Sourcing depends on where the business activity happens and how it’s structured, so this is a common area for confusion.
• Rental income: Usually sourced to where the property is located (foreign property = foreign-source rent).
• Investment income: Dividends (including amounts reported on Form 1099-DIV), interest, and capital gains can be foreign-source or U.S.-source depending on specific sourcing rules, including whether the payer is a foreign corporation.

General vs. passive baskets (why this matters)

Foreign-source income also gets sorted into categories—most commonly general and passive—and the limitation is calculated separately for each category on Form 1116. In other words, your “foreign slice” isn’t one big pool; it’s separated into buckets, and the bucket you put income into can change your credit cap.

How the cap is calculated

The FTC limitation is the IRS’s way of saying: you can only use foreign taxes to offset the U.S. tax on your foreign-source share of income. Not your entire return. Just the foreign slice.

Step 1: Figure out your “foreign slice”

Start with your foreign-source gross income, then subtract allocable deductions. What’s left is your foreign-source taxable amount for limitation purposes.

That subtraction matters because it often shrinks the slice. And a smaller slice means a smaller credit cap.

Step 2: Turn that slice into a percentage

You then compare your foreign slice to your worldwide income:

Foreign-source taxable income ÷ Worldwide taxable income

That ratio is the percentage of your total income the IRS considers foreign-source.

Step 3: Apply that percentage to your U.S. tax

Finally, you multiply that percentage by your U.S. income tax (U.S. tax liability):

(Foreign-source taxable income ÷ Worldwide taxable income) × U.S. tax

That result is your cap—the maximum FTC you can use for the year.

Why the cap is often lower than people expect

Two things commonly reduce it:

• Allocable deductions shrink the foreign slice (interest expense, some Schedule A/itemized buckets, and other deductions the IRS makes you spread across income).
• Income categories (“baskets”) are calculated separately on Form 1116 (often general vs passive), so excess credit in one bucket can’t usually offset tax in another.

FEIE, credits, and small claims without Form 1116

The FEIE and the Foreign Tax Credit (FTC) can both lower your U.S. tax bill, but they work in totally different ways. The key thing to know is that excluding income under the FEIE can reduce (or eliminate) the foreign taxes you’re allowed to use for the FTC, so the “best” choice depends on your mix of income and credits.

• What FEIE does: It excludes foreign earned income from your U.S. return, which can lower your U.S. tax.
• What that means for the FTC: You generally can’t claim the FTC for foreign taxes paid on income you excluded under the FEIE, which can reduce the credits available to you.
• When skipping FEIE can help: If you’re in a higher-tax country (or have enough foreign tax), taking the FTC instead of the FEIE can sometimes produce a better result.
• What to check before you file: Your FEIE/FTC choice can affect other benefits like the Child Tax Credit, because it changes your U.S. tax liability and the credit “stack.”
• When you can skip IRS Form 1116: You may be able to claim a small FTC directly on your return (no Form 1116) if your foreign taxes are $300 or less ($600 or less if married filing jointly) and your income is qualifying passive income reported on forms like 1099-INT/1099-DIV (and you meet the IRS conditions). Otherwise, you’ll generally attach Form 1116.

Carryovers, fixes, and filing moves

If the limitation stops you from using all your foreign taxes this year, the good news is they don’t disappear. This is really a three-part game: what happens to the leftover credit, why it got limited, and what you do on the return to fix it.

• Where unused credits go: Unused foreign tax credits can generally be carried back 1 year and carried forward 10 years — tracked separately for each income category (basket).
• Why you end up with leftovers: It’s usually the same three suspects — more U.S.-source income than you expected (dividends/RSUs), deduction allocation shrinking your foreign slice, or a timing gap where foreign tax posts after you file.
• How you can make the credit usable: Your levers are mostly timing and method: whether you treat foreign tax as paid vs accrued (when eligible), and which year you apply the credit to using the carryback/carryforward rules.
• How you report it: You generally claim the credit by attaching Form 1116, and you typically file one Form 1116 per basket when you have multiple categories of income.
• How you correct it later: If your foreign tax numbers change after filing (a foreign tax redetermination), you may need to recalculate and file an amended U.S. return (Form 1040-X).

Make the FTC work harder

The foreign tax credit limitation caps relief at the U.S. tax on your foreign-source income, so the result often comes down to the details: sourcing, baskets, deductions, FEIE choices, and Form 1116. Line those up well and the FTC can meaningfully reduce double taxation. Miss them, and you can still end up owing the IRS.

Want this handled properly, without the guesswork? Talk to Bright!Tax. Our expat CPAs will map your income, optimize FTC vs FEIE, file Form 1116 cleanly, and protect carryovers—so your foreign taxes paid turn into real U.S. tax relief.

Frequently Asked Questions