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The Foreign Tax Credit

The Foreign Tax Credit

There is a tax credit or deduction available for those who have paid taxes on foreign earned income if they also paid U.S. taxes in the same year. This is a somewhat complicated option, giving taxpayers the choice to choose to either use a deduction to reduce their taxable income or the foreign tax credit to reduce their tax liability. In most cases, the tax credit is the most valuable option; however, due to the criteria needed to use this credit, it is important to understand how and when it can be used.

Rules Regarding the Foreign Tax Credit

There are many rules and specifications that surround the foreign tax credit. For instance, if you choose to exclude income or housing costs in a foreign country, you cannot then opt to use the foreign tax credit. In addition, there are 4 basic stipulations that you must meet to use this unique credit:

1. The tax must be imposed. Any foreign taxes must be mandatory and imposed to be considered eligible for a tax credit on your U.S. tax return.

2. The foreign tax must be an income tax. The taxes must be income taxes or taxes paid instead of income taxes on the foreign income.

3. You must have paid the taxes. The foreign taxes must have been paid or accrued by you to be eligible for the foreign tax credit.

4. It must be a legal foreign tax. The tax liability must be an actual and legal tax imposed by a foreign entity, minus any refunded taxes or unallowable tax payments.

U.S. possessions (such as Puerto Rico) are considered “foreign” for the purpose of this tax credit. This means that any taxes imposed in a U.S. possession may qualify for the tax credit.

Foreign Tax Credit Limits

The foreign tax credit can only be used for taxes paid on certain types of income. Also, there are limits on the total amount that can be used as a credit on your U.S. tax return. The tax limit is a fraction of the foreign income and the total income you received in the same year. The foreign tax credit cannot be more than your U.S. tax liability. In some circumstances, tax payers may be exempt from the foreign tax credit limit, up to their tax liability.

Due to the complicated nature of the foreign tax credit or tax deduction option, a tax professional should be consulted before using this credit. You will want to ensure that the foreign income that was taxed was eligible, plus the tax must meet the four requirements above, along with other stipulations. If the foreign tax does qualify, you must also understand how to calculate the correct amount you can use as a credit. The credit also must be converted to U.S. currency. To ensure that you are meeting all these stipulations, get advice from a tax professional that is familiar with this detailed tax credit.

For more information, please see IRS Publication 514 (Foreign Tax Credit for Individuals).


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