There is a possibility that you may be suffering from double taxation. I know, we all suffer from double taxation, like when we pay sales tax when we purchase items with money that has been taxed by the federal government. Or when I used to work for the state government, and when I used my money (that was already taxed—federal income) to pay for things that were later reimbursed…I was taxed again (I know, sounds ridiculous; I had the HR department look into this and it is actually in the IRS code).
But when you suffer from double taxation between countries—from your home country and from another country—then there are ways for you to find relief.
Why Might You Pay Double Tax Without Living Abroad?
It’s not as if you are earning income abroad, in which case you would be interested in the Foreign Earned Income Exclusion.
You may pay double tax without living abroad if you hold investments and earn foreign source income tax on those in both another country and in the United States. This could include things like qualified dividends and/or capital gains (including long-term capital gains, collectible gains, unrecaptured section 1250 gains, and section 1231 gains) and interest (home mortgage interest, business interest, investment interest expense, passive activity interest, and partnership interest). Only the reduced tax (you are entitled to a reduced rate of foreign tax based on an income tax treaty between the United States and a foreign country) qualifies for the credit.
How Do You Know if You Have Been Taxed By Another Country?
One of the ways that you pay foreign tax (somewhat unknowingly) is when you hold a mutual fund with holdings in foreign companies. Mutual funds can choose whether or not to pass the credit onto the shareholders. If they have done so, then you will receive a 1099-DIV: Dividends and Distributions, with an amount of your total share of foreign taxes paid in Box 6.
How Do You Claim the Foreign Tax Credit?
You must meet these four requirements in order to qualify for the Foreign Tax Credit or Deduction:
- A tax was imposed on you
- You paid or accrued the tax
- The tax was the legal and actual foreign tax liability
- The tax was an income tax (or a tax in lieu of income tax)
Note: In order to take the Foreign Tax Deduction, you must itemize your deductions. The foreign tax credit can be taken even if you don’t itemize your deductions.
If you paid less than $300 this year in foreign taxes, then you will claim the credit in the Credits section of Form 1040: U.S. Individual Income Tax Return. If you paid over $300 (or $600 married filing jointly) in foreign taxes, then you will need to fill out IRS Form 1116: Foreign Tax Credit (Individual, Estate, or Trust). On this form, you will need to both know the foreign currency amount paid, as well as convert it into dollars.
What is the Difference between the Foreign Tax Credit and the Foreign Tax Deduction?
There are two types of tax relief for double taxation in the US and another country. One is the Foreign Tax Credit, and the other is the Foreign Tax Deduction.
A tax credit—money taken directly off of your tax bill—is more valuable than a tax deduction, which only deducts the amount of income with which you can be taxed on. The IRS explains this well, “Taken as a deduction, foreign income taxes reduce your U.S. taxable income. Taken as a credit, foreign income taxes reduce your U.S. tax liability.”
Sometimes the Foreign Tax Credit is unavailable to you, which means you would want to try for the Foreign Tax Deduction. For example, you are not allowed to claim the credit for taxes paid on income from foreign oil investments or on taxes of profits from international boycott operations. And if you make a profit from companies the US does not have diplomatic relations with, then you cannot claim the Foreign Tax Credit.
Note: The foreign tax credit can only reduce U.S. taxes on foreign source income, and cannot reduce U.S. taxes on U.S. source income.
The Foreign Tax Credit is more difficult to claim, which is why a lot of people just take the foreign tax deduction. But you will likely have a higher financial benefit from claiming the Foreign Tax Credit. Also, don’t forget that if you don’t itemize your deductions, then you cannot take the deduction anyway.