A common misconception among Americans living abroad is that they no longer have any tax responsibilities in the United States. Every American ex-pat should familiarise themselves with their tax duties and submit their forms in a timely manner since the United States continues to collect taxes from its residents even after they have gone abroad. The good news is that most foreign nationals living in the United States may decrease or eliminate their tax bill by taking advantage of available tax deductions and credits. The overseas tax credit is one such tax break accessible to ex-pats.
Overview of U.S. Tax Law
The United States is unique among developed nations in that it taxes its people even when they are not physically present in the country. This comes as news to many foreigners who have been living there. Many ex-pats worry about this since they must pay taxes in their host nation. People who move abroad often worry about having to pay taxes twice on the same money. Thankfully, this problem can be avoided altogether thanks to the Foreign Tax Credit programme established by the United States. There are, however, prerequisites that must be met in order to claim the international tax credit. Timely filing of tax returns and payment of income taxes are also requirements of the Internal Revenue Service. Many people who live abroad seek the advice of a tax expert since filing taxes is so complicated.
Problems with Double Taxation
The fear of “double taxation,” or having to pay taxes in two places (the United States and the foreign nation) is a major concern for Americans working overseas. The financial impact of having to pay twice as much in taxes might be substantial. A U.S. citizen living abroad may be able to minimize their taxable income back home and avoid “double taxation” by taking advantage of certain tax treaties. You can accomplish this by filing Form 1116 to get a foreign tax credit. The foreign tax credit paid or accumulated can be utilized as a deduction or credit on the U.S. tax return if the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction do not fully balance any foreign income.
Taxpayers have the option of claiming a credit against taxes owed or deducting the amounts paid as an itemized deduction on Schedule A. Using the amount of taxes you paid to a foreign country as a tax credit is generally a good idea. For the most part, Americans won’t have to worry about paying taxes in the United States on money earned abroad if the tax rate in their home country is greater than the one in the States. United States tax on overseas income is typically capped at the disparity between the international and domestic tax rates.
Who is entitled to claim the tax credit?
Any person, estate, or trust that has paid taxes to a U.S. territory or foreign government is eligible to get the credit. Except in exceptional cases, this credit is generally unavailable to nonresident foreigners.
The option between a Tax Credit and a Deduction
In lieu of the overseas tax credit, taxpayers may claim eligible taxes as an itemized deduction. Knowing the distinction between a credit and a deduction can help you choose the strategy that is most advantageous to your needs. If you qualify for a tax deduction, you can lower your taxable income by the amount of the deduction. If your taxable income for the year was $50,000 but you deducted $5,000, your effective taxable income would be $45,000. In contrast, when you receive a tax credit, the amount of tax you owe is reduced immediately. If your income tax is $5,000 but you qualify for a $1,000 tax credit, your effective tax rate will be just 40%, or $4,000.
In the tax system, tax credits can be either refundable or nonrefundable. When your total credits exceed your tax obligation, you are eligible for a return thanks to refundable credits. Credits that cannot be refunded do not. The overseas tax credit cannot be refunded for any reason.
Claiming Your Foreign Tax Credit: Step-by-Step Instructions
Foreign tax credits are often claimed by filing Form 1116. In some cases, as determined by the Internal Revenue Service, you may not need to file Form 8863 to claim the FTC. To make a claim for the foreign tax credit without submitting Form 1116 as an election:
- If you are filing on behalf of a trust or estate, you cannot do so.
- You can deduct foreign taxes paid up to the amount allowed by your tax status, as specified in the Form 1040 instructions.
- You are only allowed to receive profits and interest from overseas sources.
- A qualifying payee statement, such as a Schedule K-1, Form 1099-DIV, or Form 1099-INT, must detail all foreign income taxes and foreign source income.
- You cannot carry back or forward any unused foreign taxes if you claim the international tax credit without submitting Form 1116.
The United States Foreign Tax Credit
Americans living abroad can get a tax refund in the United States equal to the amount of taxes they paid to their host nation by claiming the Foreign Tax Credit. By taking this action, they will be able to reduce their US tax liability to an amount below the larger of the two tax rates. It’s possible that ex-pats who claim the Foreign Tax Credit and are resident in one of the several countries with higher income tax rates than the United States would owe no US tax and would have more than enough US tax credits to completely wipe out their US tax liability. When they realize a capital gain, for example, they can benefit from the ability to carry any unused portion of their tax credit forward for up to ten years, or back for a year.
After taking into account the Foreign Tax Credit, an ex-pat whose home country has a lower income tax rate than the United States will incur additional US tax. Expats must attach Form 1116 to their federal income tax return (Form 1040) in order to claim the Foreign Tax Credit. Filing deadlines for ex-pats are automatically extended to June 15, but they must still pay any US tax due by April 15, even if it’s an estimate. Expats can avoid paying US taxes on a portion, or all, of their earned income by filing Form 2555 to claim the Foreign Earned Income Exclusion. The amount excluded is subject to annual inflation adjustments. The threshold for qualifying for the Foreign Earned Income Exclusion was $107,600 in 2020 and $108,700 in 2021.