The information in this article is up to date through tax year 2019 (taxes filed in 2020).
As an American citizen earning income, you are required to file federal income taxes in the U.S., even if you live and work abroad. The Foreign Tax Credit allows you to deduct taxes paid to foreign governments from your American tax return, so you aren’t taxed twice for the same income.
Can I claim the Foreign Tax Credit?
To determine if you are eligible to take the Foreign Tax Credit, first ask yourself the following questions:
- Was I required to pay foreign tax?
- Did I pay my foreign tax bill?
- Was the tax legal?
- Was the tax technically income tax (or the equivalent of income tax)?
If you can answer yes to all of the above, you may qualify for a break that is equal to either all of or a portion of the amount of tax you paid to the foreign country. Ultimately, the Foreign Tax Credit amount depends on your tax liability, how much total income you earned, and how much of that income was foreign.
How much is the Foreign Tax Credit worth?
Your Foreign Tax Credit is equal to the amount of foreign tax you paid or the “foreign tax credit limit,” whichever is less.
Determining the Foreign Tax Credit limit
To calculate your limit, multiply your U.S. tax liability by a fraction. That fraction is the amount of income you earned abroad divided by your total income from all sources, foreign and domestic.
For example, if you earned $20,000 in Madrid and that was your total income for the year, then $20,000 / $20,000. If your American tax liability is $600, you would multiply $600 x ($20,000/$20,000) = $600 foreign tax credit limit.
Let’s say you paid $700 to the Spanish government for the year. In that case, your U.S. tax credit will be worth $600 (your limit).
Now, let’s say you only paid $500 in foreign income tax. In that case, you will receive a tax credit for the entire $500.
If you take the foreign tax credit and you paid more in taxes than your limit for the tax year, you may be able to carry forward your excess liability to the next year.
TaxSlayer will automatically calculate your credit for you when you enter your foreign income information into the program. See where to find the Foreign Tax Credit in TaxSlayer.
How does the Foreign Tax Credit work?
If your income qualifies you for the Foreign Tax Credit, you can apply the amount as a credit toward your liability or to write it off as an itemized deduction. You can change how you choose to claim it from one tax year to the next. Note: The Foreign Tax Credit can only be used to lower your tax liability for income you earned from a foreign country. You can’t use it to reduce the amount of taxes you owe for U.S.-source income.
For most people, it makes more sense to take the credit instead of the itemized deduction. This is due to the fact that you are allowed to take a tax credit even if you take the standard deduction. Since the Tax Cuts and Jobs Act was signed into law, many more taxpayers find that the standard deduction offers them the biggest tax benefit.