The foreign tax credit

On Behalf of | Feb 22, 2022 | IRS Tax Law

For Texas residents who own property in multiple countries, the foreign tax credit helps to reduce the double tax burden of foreign source income. There are many rules for the foreign tax credit, including how foreign taxes qualify or the qualifying tests.

Qualifying tests for the credit

The IRS has four tests that a foreign tax source must meet to qualify for the credit. A person must pay or accrue the foreign tax imposed on them. The foreign tax must be a legal and actual tax liability. The tax needs to be income or a tax instead of income. Usually, income taxes from a foreign country or U.S. territory qualify for the foreign tax credit. Accrued or paid taxes to another country or U.S. territory instead of income tax may qualify for the foreign tax credit.

Foreign taxes that don’t qualify

Under tax law, some taxes are claimed as an itemized deduction but don’t qualify for foreign tax credits. Refunded taxes and taxes that didn’t require payment in the foreign country don’t qualify. Returned taxes as a subsidy don’t qualify under foreign tax credits. Sometimes, withheld foreign taxes on gains and income from foreign properties or stocks don’t meet the minimum for the credit.

Certain countries aren’t eligible for foreign tax credits. Taxes from any country that the Secretary of State designates as helping international terrorism aren’t eligible. In addition, taxes from any country that the U.S. doesn’t recognize or has no diplomatic relationships with aren’t eligible.

Choosing a credit or deduction

The IRS gives qualified foreign taxes a credit or deduction. Form 1040 allows a person to itemize deductions of foreign taxable income. Form 1116 with Form 1040, Form 1040-SR or Form 1040-NR help people apply for foreign tax credits. The choice is annual for all foreign taxes.

There isn’t any double taxation under the foreign housing exclusion. A Form 1116 helps figure out the credit, but the foreign tax credit is on the smaller amount of paid foreign taxes. Sometimes, people don’t claim the entire amount of paid foreign taxes during the year; people can carry over unused foreign income taxes for up to a decade.