Foreign Tax Credit
The foreign tax credit is a type of tax credit the IRS provides to some taxpayers. It helps to prevent double taxation. In this article, we will explain how the foreign tax credit works and how to properly claim it.
Tax Credit vs. Tax Deduction
First, it is important to understand the difference between tax credits and tax deductions. A tax deduction only lowers your taxable income. This means you are only able to reduce your income by a percentage based on your tax bracket. Whereas a tax credit allows you to reduce your tax bill on a dollar-for-dollar basis.
How the Foreign Tax Credit Works
The foreign tax credit can help those who pay taxes to foreign countries or U.S. possessions and owe taxes to the U.S. on that same income. This credit will directly reduce your U.S. tax liability so as to prevent double taxation.
You report and calculate the foreign income tax credit on IRS Form 1116. Eligible income for this tax credit includes wages, dividends, interest, royalties, and war profits. Taxes you pay on real property and/or personal property sales do not qualify for this credit. However, you may be able to deduct it through your Schedule A.
Who Can Claim the Credit
There are three categories of people who can claim the foreign tax credit. First are U.S. citizens. Second, are U.S. resident aliens. Third, are non-resident aliens who are bona fide residents of Puerto Rico for the entire tax year and paid foreign income taxes that are connected to a business or trade in the United States.
Four Point Qualification Test
To qualify for taking the foreign tax credit, you must meet a four-point test. This includes:
- The tax must be imposed on you by a foreign country or U.S. possession.
- You must have paid or accrued the tax to a foreign country or U.S. possession.
- The taxes you report must be the legal and actual foreign tax liability that you paid or accrued during the tax year.
- The tax you report must be an income tax or tax in lieu of an income tax.
Refundable vs. Non-Refundable
Some foreign tax credits are refundable, and others are non-refundable. A refundable tax credit is one that results in a refund check if your credit is higher than your tax liability. On the other hand, a non-refundable tax credit will not result in a refund check, it will only reduce the taxes that you owe to zero dollars.
Claiming the Foreign Tax Credit
If you think you will qualify for the foreign tax credit, talk with your tax preparer to begin planning for the next tax season.
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