As the global economy continues to expand, more U.S. taxpayers, including both individuals and businesses, earn income overseas and become responsible for paying foreign taxes. For tax preparers, staying informed about the rules that apply to foreign-sourced income is essential. The Foreign Tax Credit (FTC) is an important provision in the U.S. tax code that helps prevent double taxation on income earned outside the country.
This guide explains the purpose of the Foreign Tax Credit, the key eligibility requirements, the major limitations, how to complete Form 1116, and steps to calculate the credit accurately.
What is the Foreign Tax Credit?
The Foreign Tax Credit is a provision in the U.S. tax code that allows taxpayers to reduce their U.S. income tax by the amount of income tax they paid to a foreign country. It’s designed to prevent double taxation on income earned outside the United States.
The credit can apply to several types of foreign-sourced income. This includes wages, self-employed income, dividends, interest, and rental income. To qualify, the tax must be an income tax (or a tax treated as an income tax) that was legally owed and paid to a foreign government.
The Foreign Tax Credit is optional. Taxpayers may choose to claim the credit, take a deduction for foreign taxes, or use other options such as the Foreign Earned Income Exclusion (FEIE) if they qualify.
Who can claim the Foreign Tax Credit?
The Foreign Tax Credit is available to U.S. taxpayers who pay or accrue income taxes to a foreign country or U.S. possession on foreign‑sourced income. This includes individuals, estates, trusts, and certain domestic corporations. To qualify, the taxpayer must have paid a foreign income tax that is legally owed and based on income earned from sources outside the United States.
In most cases, the credit can be claimed by any U.S. citizen or resident alien who reports foreign-sourced income on their U.S. tax return. A nonresident alien generally cannot claim the Foreign Tax Credit, but there is an important exception. A nonresident alien may take the credit if they were a bona fide resident of Puerto Rico for the entire tax year.
Tax preparers should also ensure that the income is properly classified as foreign‑sourced, that the tax paid meets the definition of an income tax or compulsatory payment, and that the taxpayer maintains documentation to support the credit. Understanding these requirements helps prevent errors and ensures the credit is applied correctly.
Foreign Tax Credit limitations
While the Foreign Tax Credit offers significant relief by reducing double taxation, it is subject to limitations that tax preparers must navigate. The FTC limitation is designed to prevent U.S. taxpayers from using foreign taxes to offset U.S. tax on U.S. sourced income. The limitation caps the allowable credit based on the ratio of foreign-sourced taxable income to total taxable income.
This limitation is applied before any foreign tax credit carryovers are considered. As a result, taxpayers may not be able to claim the full amount of foreign taxes paid in the current year, leading to unused credits that must be tracked for future years.
Source of income
To qualify for the FTC, the income must be from a foreign source. This means the income must be earned from activities, services, or investments outside the United States. If your client lived in another country but earned money from U.S. sources, this income wouldn’t be eligible for the credit.
Type of foreign taxes
Only certain types of foreign taxes are eligible for this credit. In general, eligible taxes must be foreign income taxes or similar taxes that take the place of income tax. However, not all foreign taxes meet this requirement. For example, foreign property taxes typically cannot be applied toward the credit, but they may qualify as a foreign tax deduction.
How the Foreign Tax Credit limit is calculated
The Foreign Tax Credit limit determines the maximum amount of credit the taxpayer can claim each year. The limit is calculated by multiplying the total U.S. tax liability by a fraction:
- The numerator of the fraction is your client’s taxable income only from foreign sources.
- The denominator is their total taxable income from both the U.S. and foreign sources.
You’ll make this calculation on Form 1116 (discussed below).
Foreign Tax Credit limit exceptions
There are certain exceptions to this limitation that allow someone to claim a larger credit without using Form 1116:
- Their only foreign source gross income for the tax year is passive income (See “Separate Limit Income” in Publication 514 for a definition of passive income.)
- Their qualified foreign taxes for the tax year are not more than $300 ($600 if filing a joint return).
- All gross foreign income and foreign taxes are reported to the taxpayer on a payee statement like Form 1099-DIV or 1099-INT.
Choosing this election may make sense if it significantly increases your client’s credit amount, but if they choose it, they won’t be able to carry forward or carry back any unused foreign tax credit from the current year.
Threshold for high tax kick out
If the foreign tax rate on a specific item of income exceeds 250% of the U.S. tax rate on the same income, the excess foreign taxes paid are not eligible for the foreign tax credit. This provision is designed to keep the amount of the credit similar to the amount of U.S. taxes that would be imposed on the income.
Foreign Tax Credit carryovers
If your client’s allowable FTC for the year is less than their qualified foreign taxes paid or accrued, the excess doesn’t disappear. In general, it can be carried back 1 year and carried forward up to 10 years. However, several rules control how and when these carryovers can be used.
For example, carryovers are tracked and applied separately by income category. A carryover from one category cannot offset U.S. based tax on income in another category. Common income categories include passive income and general income.
Additionally, FTC carryovers follow strict expiration windows. Unused credits may be carried back one year and carried forward for up to ten years, and any carry forwards must be used beginning with the oldest year first.
Each year, the IRS requires that the current‑year FTC limitation be calculated before any prior‑year amounts can be applied. After the limitation is determined, a taxpayer must first apply any eligible carryback from the immediately preceding year, and only then may apply carryforwards, again in order from the earliest remaining year in the matching income category.
The Foreign Tax Credit vs. Deduction
The IRS allows taxpayers to choose between taking the Foreign Tax Credit or taking a deduction for foreign income taxes paid. In most cases, taking the credit is the more beneficial choice because it reduces their U.S. tax dollar for dollar, while the deduction only lowers taxable income.
Your clients cannot take both the credit and the deduction for the same income, and they cannot split their foreign income taxes, choosing the credit for some and the deduction for others. They must choose the credit or deduction for all their foreign income each year.
Note: Other types of foreign taxes that are not eligible for the FTC, such as property taxes, can still be deducted from taxable income even if your client is taking the Foreign Tax Credit.
A deduction may be worth considering in some circumstances. It can make sense when a taxpayer’s FTC limitation is very low, such as years with little or no foreign-sourced income, meaning most foreign taxes would become unusable credits or eventually expire. Some individuals in very low U.S. tax brackets may also see minimal advantage from the credit, making a deduction comparable or simpler.
Foreign Tax Credit vs. Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion is only available to U.S. taxpayers whose tax home is in a foreign country, such as U.S. expatriates. So, if your client lives in the U.S. but makes money from foreign sources, they would not qualify for the FEIE.
This provision allows taxpayers to exclude foreign earned income from their taxable U.S. federal income, up to a limit of $130,000 (up to $260,000 if both taxpayers on the return have income that qualifies). In some cases, it may be more beneficial than the foreign tax credit. For example, if your clients have an income below the $130,000 limit, they could eliminate any taxable income. Or, if they pay relatively little in foreign taxes, their foreign tax credit would be minimal as well.
On the other hand, the foreign tax credit is often the better choice for high-income taxpayers. Additionally, there is no carryover for the FEIE, and if a taxpayer completely eliminates all of their earned income using the FEIE, they may not be able to claim certain credits such as the Child Tax Credit or make contributions to IRA accounts. If your client qualifies for the FEIE, you’ll need to weigh the two options carefully, considering not only their tax liability for the current year but also the possibility of Foreign Tax Credit carryover in future years and other financial considerations like their ability to contribute to IRAs.
How to fill out Form 1116: Foreign Tax Credit
Form 1116 is required for most taxpayers claiming the Foreign Tax Credit because it categorizes foreign income, reports foreign taxes, and applies the FTC limitation. It can sometimes be avoided when the taxpayer meets the IRS’s small credit rules, but those situations are infrequent and should be used cautiously.
When preparing this for common errors include misclassifying income into the wrong income category, using incorrect foreign income currency exchange rates, failing to track carryovers by year and category, and overlooking adjustments for refundable portions of the credit.
Selecting category of income
Before you get to Part I, you’ll check one of seven boxes to specify the category of income, such as from general sources, passive income, or foreign branch income. Even if your client has multiple types of foreign income, you must check only one box per form. You’ll fill out a separate Form 1116 for each type of income.
Part I: Taxable Income and Loss from Sources Outside the U.S.
In Part I of Form 1116, you’ll list each country and the gross income sourced to that location. Income from multiple countries generally cannot be lumped together unless they fall into specific IRS groupings (such as “country code” regions used for certain types of income). To ensure accurate sourcing and prevent errors, it’s best to list each country separately when the form provides space.
When reporting foreign income, remember that amounts earned in foreign currency must be converted to U.S. dollars using the appropriate exchange rate for the date the income was received or accrued. This ensures the income reported aligns with IRS requirements and matches the amounts used in the FTC limitation calculation.
Additionally, foreign‑source income often comes from accounts or assets held abroad. While not directly part of Form 1116, this may trigger other reporting obligations, such as FBAR: Foreign Bank Account Reporting (FinCEN Form 114) or Form 8938. As a tax preparer, you should confirm whether those filings apply when completing this section.
Part II: Foreign Taxes Paid or Accrued:
In this section, you’ll document the foreign taxes paid or accrued during the tax year, depending on the method your client elects. Taxpayers must use one method consistently for all countries and all foreign taxes for that year.
For example, if a client chooses the paid method, they may only report foreign taxes actually paid during the tax year. If they choose the accrued method, they may report taxes that became a legal liability during the year, even if not yet paid.
Foreign taxes are generally paid in a currency different from the U.S. dollar, so you’ll need to determine the appropriate exchange rate on the date the foreign taxes were paid or accrued to convert the figures into U.S. dollars.
Part III: Figuring the Credit
Here, you’ll calculate the foreign tax credit using the credit limitation formula to determine the maximum allowable foreign tax credit (i.e. multiply their total U.S. total by a fraction where the numerator of the fraction is your client’s taxable income only from foreign sources and the denominator is their total taxable income from both the U.S. and foreign sources). This section also accounts for any high-tax kickouts or carryover from previous years’ foreign tax credits.
Part IV: Summary of Credits from Separate Part IIIs
If your client had multiple categories of foreign income and therefore multiple 1116 forms, in this section you will combine the figures from Part III of each different form to get your final total foreign tax credit.
