Foreign Tax Credit: Definition, How to Qualify and Expat Eligibility

The United States taxes citizens on their income, no matter where it's earned. Here's how to keep the tax bill down.

Tina OremJuly 6, 2020

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If you’re an American who lived or worked outside the United States, you almost certainly have to file a tax return with the IRS, and you may qualify for the foreign tax credit. And if you had investments or assets outside the U.S., you may have some other paperwork to do, too.

What is the foreign tax credit?

The foreign tax credit is a U.S. tax credit for income tax you pay to other countries. The general objective is to help taxpayers avoid double taxation on income received from foreign sources.

What follows is a general overview of the basics of taxes on foreign income. The rules are complicated, there are a lot of exceptions to those rules and there are a lot of special forms and deadlines. If you worked abroad, lived abroad, or owned investments or other assets abroad during the tax year, you should probably consult with a qualified tax pro.

U.S. citizens have to report foreign income

U.S. citizens and resident aliens are required to report their worldwide income on their U.S. tax returns every year. That means you must report all the money you made inside the United States, as well as any foreign income you received during the tax year.

What counts as foreign income? Income from all sources outside of the United States, even if you don’t get a W-2 or a 1099 showing the income. All of these things may count, even if the money came from outside the United States:

  • Salaries, wages and tips

  • Commissions and bonuses

  • Professional fees

  • Certain allowances or reimbursements for cost of living, home leave or moving

  • Dividends, interest and capital gains

  • Gambling winnings

  • Alimony

  • Social security benefits, pensions and annuities

  • Business profits

  • Royalties

  • Rent

  • Certain scholarships or fellowships

  • Employer-provided lodging, meals or use of a car

In general, you’ll report your income in U.S. dollars, which means exchange rates are a factor in preparing your tax return. It’s another good reason to hire a tax pro if you’ve got foreign income.

Some foreign income may be tax-free

Just because you have to report income doesn’t necessarily mean Uncle Sam will send you a tax bill. For example, two mechanisms may keep a hunk of your foreign income and assets from the IRS: the foreign earned income exclusion, and the foreign tax credit or deduction.

How the foreign earned income exclusion works

In general, the foreign earned income exclusion allows you to treat up to $107,600 of your income in 2020 as not taxable by the United States. You have to live and work in a foreign country for this to apply. To claim the exclusion, file IRS Form 2555 with your tax return.

  • Some of your housing expenses may count, too. (And if you’re self-employed, they might be deductible.) IRS Publication 54 has the details.

  • Typically, the amount of income you can exclude is prorated by the percentage of days during the year you were outside the United States.

How the foreign tax credit and foreign tax deduction work

Some taxpayers may have to pay income tax to the countries they live in and then pay income tax on the same earnings to the United States. The IRS is aware of this double-taxation situation. Generally, you can get a tax break for income taxes you pay to other countries. The IRS gives taxpayers the option of either deducting the foreign income tax they paid, or claiming those taxes as a foreign tax credit.

  • Usually, claiming the foreign tax credit saves more money than taking the deduction (Learn more about the difference between tax credits and tax deductions.)

  • Your tax preparer should figure your tax liability both ways so you can choose the one that saves you the most money.

  • You can’t take this tax break on income you excluded using the foreign tax exclusion. In other words, if you lived and worked in a foreign country and therefore excluded $107,600 of your income from U.S. taxes in 2020, you can’t also deduct from your U.S. tax return the income taxes you paid in that foreign country on that same $107,600. (The calculations can be tricky here, so be sure to consult with a qualified tax pro for help.)

  • To claim the foreign tax credit, file IRS Schedule 3 on your Form 1040; you may also have to file Form 1116.

  • If you choose the foreign tax deduction route, use Schedule A.

You may also have to report foreign assets to the IRS

You may need to fill out IRS Form 8938 to report assets you owned that were located outside the United States. This includes financial accounts at non-U.S. financial institutions, as well as stocks or other financial instruments issued by non-U.S. companies or businesses you owned or partially owned. You may need to do this even if you lived in the United States all year. Here are the general thresholds.

If you live in the U.S.

You probably need to file Form 8938 if your filing status is ...

... and the value of the assets on the last day of year is more than ...

... OR if the value of the assets on any day during tax year is more than ...

Single

$50,000

$75,000

Married, filing jointly

$100,000

$150,000

Married, filing separately

$50,000

$75,000

If you live outside the U.s.

You probably need to file Form 8938 if your filing status is ...

... and the value of the assets on the last day of year is more than ...

... OR if the value of the assets on any day during tax year is more than ...

Single

$200,000

$300,000

Married, filing jointly

$400,000

$600,000

Married, filing separately

$200,000

$300,000

Watch out: The failure-to-file penalties for Form 8938 can run $10,000 or sometimes even $50,000. If you get caught underpaying, the penalty can be 40% of the amount you underpaid. If fraud is involved, that penalty rises to 75%. And on top of all that, the IRS can also hit you with criminal charges.

Reporting your foreign bank accounts might be on the to-do list

If the combined balance in your foreign financial accounts is $10,000 or more at any point during the year, you’ll probably have to report those accounts to the U.S. Treasury — even if the accounts don’t generate any income. That includes accounts such as bank accounts, brokerage accounts and even mutual funds.


Optimize the cash in your bank accounts


  • To report foreign bank accounts, file Financial Crimes Enforcement Network (FinCEN) Form 114, which is the Report of Foreign Bank and Financial Accounts (also called “FBAR”). If you don’t have everything you need to file your FBAR by April 15 (note that the filing and payment deadline in 2020 is now July 15), you can get an extension to Oct. 15.

  • These places don’t count as foreign countries in the context of this rule: the Northern Mariana Islands, the District of Columbia, American Samoa, Guam, Puerto Rico, the U.S. Virgin Islands and the Trust Territories of the Pacific Islands.

  • And these types of foreign financial accounts typically don’t count: correspondent/nostro accounts, accounts owned by a governmental entity, accounts owned by an international financial institution, accounts in a U.S. military banking facility, or accounts in an IRA, retirement plan or trust.

  • If you blow off the FBAR, you can face some financial penalties and could even go to jail. Good news, though: The IRS doesn’t penalize people who file their FBARs late if it decides you had a good reason for the late filing.

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