If you’re an American living abroad, the Foreign Tax Credit is a great way to reduce your US tax liability. But what is it exactly?

The credit is a dollar-for-dollar representation of the income taxes you paid outside the US. It can actually wipe out your US tax liability.

1. Calculate Your Foreign Taxes

The credit is limited to the difference between your foreign taxes paid and the US tax liability on your gross foreign income. You must file Form 1116 to claim the credit. You can find detailed instructions on this form as well as IRS Publication 514 on the IRS website. The calculations required to determine your FTC are fairly complex, particularly if you have both passive and general income and if you record your income using the cash or accrual method of reporting.

It’s also important to know that not all taxes are eligible for the FTC. For example, the IRS previously didn’t consider French social contribution taxes (deducted from paychecks) as income taxes and thus they were not eligible for the credit. However, the IRS has since changed its position and now these taxes are eligible for the credit. Likewise, German solidarity taxes are now eligible. Any unused credits can be carried back or forward for up to 10 years.

2. Determine Your Itemized Deductions

The IRS requires that you keep detailed records of your income to ensure that you are not overstating or understating your foreign taxes. It’s also important to know that the limit on the credit is based on your returns from previous years, so you must be sure that you are accurately reporting all of your income earned abroad.

The tax credit is designed to reduce double taxation that occurs when income is subject to both US and foreign taxation. Only taxes paid or accrued that are imposed on you as an individual or a corporation do qualify for the credit. This includes general income category items such as salary, wages, and self-employment income, as well as passive category items such as dividends, interest, royalties, annuities, and rental income.

There is a carryover and carryback for unused credits up to 10 years after the year in which they were earned. This carries over from year to year and can be used to lower any remaining tax liability owed for that particular year.

3. Claim the Credit

As an expat, you have the option of claiming foreign income taxes as a credit on your tax return or as a deduction. It’s important to understand the pros and cons of each so you can make the best choice for your situation.

Generally, you can claim a credit for the smaller of the amount of foreign taxes paid or accrued, or the amount of United States tax attributable to your foreign source income. You must use Form 1116 to figure the credit. There are special rules for passive income, foreign taxes resourced under a tax treaty and taxes on earnings from sanctioned countries.

Some people choose to take a deduction instead of the credit. However, you cannot claim both for the same year’s taxes. It’s important to discuss this with your tax preparer so you can be sure you’re maximizing your savings. NerdWallet’s content team is made up of subject matter experts who conduct thorough research using a variety of sources including peer-reviewed studies, government websites, academic research and interviews with industry experts.

4. Pay Your Taxes

The purpose of the foreign tax credit is to reduce a double tax burden when your income is taxed by both the United States and a foreign country. However, you can only use the credit to offset your U.S. tax liability for the year you paid or accrued the foreign taxes.

To qualify for the foreign tax credit, you must actually pay or accrue the foreign taxes you’re claiming. You also can’t claim foreign income taxes you don’t legally owe, including those eligible for refund by the foreign country. Additionally, the foreign taxes you claim must be an income tax or a tax in lieu of an income tax.

The foreign tax credit is a great tool for expats who work abroad to protect themselves from the burden of double taxation by the United States and their home countries. But it’s important to understand the rules of the credit, and how they differ from other deductions and credits, before using it.

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