Don’t think the foreign tax credit is for diplomats and ex-pats only. You don’t have to live in a foreign country in order to be eligible for the foreign tax credit. How is the world can that be possible? Well think about your investments: you may not live overseas but your money might be! If you own a mutual fund that has holdings in a foreign company than you own stock in another country. You may have paid tax on your earnings, to the government of the foreign country in which your stock’s company is located.
Why is There a Foreign Tax Credit?
Uncle Sam doesn’t want you to pay taxes twice on the same earnings so if you paid the foreign government then you don’t have to pay the IRS. You would claim the foreign tax credit, or in some cases a foreign tax deduction. Usually a tax credit is more valuable than a tax deduction. That’s because a credit reduces your bill like a coupon: get money taken off your total owed. A deduction, on the other hand, reduces your taxable income. The tax you owe the IRS is a percentage of your taxable income, so reducing your taxable income is nice but not as valuable as the credit. A $100 deduction might be worth an extra $10 in your pocket whereas a $10 credit is worth exactly that: $10.
So…Why Would Anyone Take the Deduction Instead of the Credit?
Well sometimes the foreign tax credit isn’t available. Some taxes are only applicable to the deduction. You can’t claim the credit for taxes paid on income from foreign oil investments. I guess the government wants to encourage investment in domestic oil by discouraging investment in foreign oil. You also can’t claim the foreign tax credit on taxes of profits from international boycott operations. Uncle Sam doesn’t want your money involved in international politics. Another no-no is claiming the foreign tax credit on profits on companies with which the USA doesn’t have diplomatic relations. You can find the list of such “bad” countries with the Secretary of State. These are countries involved in lots of terrorism or who have governments that we don’t recognize.
There are more and more types of foreign income on which the taxes may not be removed by the foreign tax credit. Therefore, try the foreign tax deduction and you might have some luck.
How Do I Claim the Foreign Tax Credit?
That depends on how much foreign tax you paid during the tax year. If it’s under $300 then you can simply claim the foreign tax credit under the Credits section of IRS Form 1040. If it’s more than $300 then you must use IRS Form 1116, called Foreign Tax Credit (Individual, Estate or Trust).