How Foreign Tax Credits Work

The foreign tax credit is one benefit available to taxpayers who earn money from outside the U.S., but it isn't the only one. Tax filers may also be entitled to a foreign tax deduction or to seek an exclusion for some of the money they make [source: IRS].

Before you can decide which option — or options — is best for you, it's important to understand the terminology. A tax credit reduces the money you owe at the end of the year on a dollar-for-dollar basis. So if you owe $5,000 and you get a $3,000 credit, the tax man will expect to get $2,000 from you. A deduction, on the other hand, reduces your total taxable income. A person who makes $50,000 in taxable income over the year and takes a $3,000 foreign tax deduction will be taxed as if he or she made $47,000 [source: IRS].

The IRS generally advises taxpayers to take the foreign tax credit rather than the deduction because it is likely to mean more tax savings for most people. Claiming the deduction may also be more work, as it requires filing an itemized Form 1040 Schedule A. U.S. taxpayers can't claim the foreign tax credit and foreign tax deduction in the same year [sources: IRS, IRS].

A person also can't claim a credit or deduction for foreign income he or she excludes when calculating tax obligations. The foreign earned income exclusion is available to citizens who either live in another country for the entire tax year, or reside in the U.S. but is a citizen or national of another country with which the U.S. has a tax treaty. These individuals can exclude up to $99,200 in income in 2014, meaning that this money isn't counted as part of their income for U.S. tax obligation purposes. A similar exclusion is also available for foreign housing costs [sources: IRS, IRS].

In order to be eligible for the foreign tax credit, a taxpayer must meet each of these four requirements:

Married couples who file a joint tax return can claim the credit on any eligible taxes paid by either spouse. The total amount of the eligible credit is also reduced by any sums that are eligible for a foreign earned income or foreign housing exclusion [source: IRS].

A particular foreign tax payment will qualify for the credit only if it isn't refundable and not used to subsidize someone else's tax liability. The tax must also be paid to a country that hasn't been designated by the Secretary of State as one that repeatedly provides support for acts of international terrorism, that the U.S. has diplomatic relations with and for whom the U.S. recognizes the country's government [source: IRS].

A tax deducted from wages is a good example of the type of payments intended to be covered by the credit. That includes money paid to U.S. possessions like Puerto Rico and American Samoa [source: IRS].

Once you determine that you're eligible for the foreign tax credit, the next question is: How much of a credit can you get? Typically, credit seekers are required to file a Form 116. This document is used to calculate both the amount of your credit and the maximum amount of the credit that you can take [source: IRS].

The total amount of the tax credit can't exceed the total of your U.S. tax obligation multiplied by a fraction. The fraction is calculated by taking your taxable income from sources outside of the U.S. and dividing it by your total taxable income from U.S. and other sources. Consider, for example, a person who makes $100,000 in the U.S. and $50,000 in Canada (after accounting for any exclusions) and has a U.S. tax obligation of $10,000. The maximum foreign tax credit that this individual can obtain is $3,300 ($10,000 x 1/3). If the same person earns all $75,000 in Canada and $75,000 in the U.S., his or her maximum credit would be for $5,000 ($10,000 x 1/2) [source: IRS].

Certain tax filers are exempt from these limits. That includes people whose foreign tax obligation is no more than $300 ($600 for joint filers) and whose only foreign source of income is deemed "passive income." This form of income refers to money derived from dividends, interest rent, royalties, annuities and the like [sources: IRS, IRS].

Finally, a note about being straight with the tax authorities. If you're entitled to a foreign tax credit or exclusion, you may be thinking "Hey, why don't I just make things a little easier and 'forget' to mention some of that foreign income to the IRS. I'm not going to get taxed on it anyway." This, of course, is a bad idea. The consequences of failing to report income or assets can include additional taxes, money penalties and even jail time [source: IRS].