If you are an American who has lived or worked outside of the United States, you will almost certainly need to file a tax return with the IRS and be eligible for the foreign tax credit. And if you've had investments or assets outside of the United States, you may have other paperwork to deal with.
What is the foreign tax credit (FTC)?
The foreign tax credit (FTC) is a U.S. tax credit for income taxes paid to other countries. Taxpayers can deduct the foreign income tax they have paid or claim these taxes as a foreign tax credit. The objective is to help taxpayers avoid double taxation of foreign income.
Below is an overview of the basics of foreign income tax. The rules are complicated, and there are many exceptions to these rules, as well as many special forms and deadlines. If you have worked overseas, lived overseas, or held investments or other assets overseas during the tax year, you should probably consult a qualified tax professional.
U.S. citizens must declare their foreign income.
U.S. citizens and resident aliens must report their global income on their U.S. tax returns annually. This means you must report all money you earned in the United States and any foreign income you received during the tax year.
What counts as foreign income? Income from all sources outside the United States, even if you don't receive W-2 or 1099 income. All of these things can count, even if the money comes from outside the United States:
Salaries, wages, and tips.
Commissions and bonuses.
Professional fees.
Certain allowances or reimbursements for living expenses, home vacations, or moving expenses.
Dividends, interest, and capital gains.
Gambling winnings.
Alimony.
Social security benefits, pensions, and annuities.
Business benefits.
Royalties.
Rent.
Certain scholarships or grants.
Accommodation, meals, or use of a car provided by the employer.
You typically report your income in U.S. dollars, which means you should consider exchange rates when preparing your tax return. Another good reason to hire a tax professional is if you have foreign income.
Certain foreign income may be exempt from tax.
Just because you have to report income doesn't mean Uncle Sam will necessarily send you a bill. For example, two mechanisms may withhold certain foreign income and assets from the IRS: foreign income exclusion and foreign tax credit or deduction.
How does the foreign-earned income exclusion work?
Generally, the foreign-earned income exclusion allows you to treat up to $112,000 of your 2022 income as not subject to U.S. tax. As of 2023, the exclusion is $120,000. To claim this exclusion, complete IRS Form 2555 with your tax return. You must live and work in a foreign country to apply.
Some of your living expenses may also count. (And if you're self-employed, they may be deductible.)
Usually, the income you can exclude is proportional to the percentage of days during the year you were outside the United States.
How does a foreign tax credit work?
You can usually get tax relief on the income taxes you pay in other countries. Some taxpayers may have to pay income tax in their country of residence and then pay tax on the same income in the United States. The IRS is aware of this double taxation situation. The IRS allows taxpayers to deduct foreign income taxes they have paid or claim those taxes as a foreign tax credit.
Generally, claiming the foreign tax credit saves you more money than deducting it (learn about the difference between tax credits and tax deductions).
Your tax advisor should calculate the tax payable in both directions so that you can choose the one that saves you the most.
You cannot obtain this tax benefit on excluded income by excluding foreign tax. If you worked in a foreign country and excluded $112,000 from your U.S. taxable income in 2022, you also cannot deduct taxes on your tax return income in the United States on the income you paid in that foreign country on the same $112,000. (The calculations can be a bit tricky here, so be sure to consult a qualified tax professional for help.)
To claim the foreign tax credit, complete IRS Schedule 3 Form 1040; you may also need to complete Form 1116.
You may also need to report foreign assets to the IRS.
You may need to complete IRS Form 8938 to report property you own located outside the United States. This includes financial accounts at financial institutions outside the United States, as well as stocks or other financial instruments issued by companies or businesses outside the United States that you own in whole or in part. Do this even if you have lived in the United States all year.
Note: Penalties for not completing Form 8938 can be as high as $10,000 or even $50,000. If you are caught underpaying, the fine can be up to 40% of the amount you underpaid. If it is a fraud, this penalty is 75%. The IRS can also charge you with criminal charges.
Reporting your offshore bank accounts may be on your to-do list
If the combined balance of your offshore financial accounts is $10,000 or more at any time during the year, you will likely have to report those accounts to the U.S. Treasury, even if the accounts do not generate any income. These include accounts such as bank accounts, brokerage accounts, and even mutual funds.
To report foreign bank accounts, complete Financial Crimes Enforcement Network (FinCEN) Form 114, which is the Foreign Bank and Financial Account Report (also known as "FBAR").
These locations are not considered foreign countries for purposes of this rule: Northern Mariana Islands, District of Columbia, American Samoa, Guam, Puerto Rico, US Virgin Islands, and Trust Territories of the Pacific Islands.
And these types of foreign financial accounts generally don't count: U.S./correspondent accounts, accounts held by a government entity, accounts held by an international financial institution, accounts at a U.S. military banking institution, or accounts in an IRA, retirement plan, or trust.
If you skip FBAR, you could face fines and even go to jail. There's good news, though: the IRS doesn't penalize people for filing their FBAR late if it decides you had good reason to file late.
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