To many people, foreign investments are very attractive. However, when calculating the potential dual-country tax liability, the blush fades from the rose. That’s especially true in many quasi-socialist countries, like France, the UK, and Spain, where taxes are quite high. Fortunately, the Foreign Tax Credit offers a great deal of relief.
Expat or domestic taxpayers may use the FTC as either a true tax credit (dollar-for-dollar tax liability reduction) or a deduction (reduction of taxable income). A tax professional can advise you as to which approach is best. The answer depends on your total financial position, and not just on the amount of foreign investment income.
FTC Basics
Generally, the Foreign Tax Credit gives credit for foreign taxes paid, and thus reduces U.S. tax liability. The amount is tied to the amount of foreign taxes paid, as opposed to the amount of foreign tax liability. To calculate the amount, taxpayers or tax prepares use Form 1116 to divide total investment income by total foreign income and achieve a percentage. The FTC also contains a rather unusual carry-over provision. Any excess FTC credit may be used to reduce investment tax liability in future years.
Additionally, the Foreign Tax Credit only applies to passive (unearned) income, and foreign income taxes. Both these terms have very specific meanings in the Tax Code. In most cases, passive income is limited to capital gains, dividends, and interest. And, sales and property taxes are definitely not income taxes.
FTC Exclusions
Citizens who live in a U.S. territory other than Puerto Rico are not technically “expats” and therefore they do not qualify for the FTC. Moreover, if the investment income originated in a country which harbors terrorists, the FTC is inapplicable. That’s not the same thing as an organization which sponsors terrorism. In this context, guilt by association is all that counts.
Moreover, taxpayers who hold more than $50,000 in foreign assets at the end of a tax year must file Form 8938 to comply with the Foreign Account Tax Compliance Act. Most foreign banks, even in Switzerland and other traditional tax anonymity countries, file FATCA reports with the federal government. So, if your Form 8938 does not mirror the bank’s report, there is trouble brewing.
Roughly the same thing applies to FBARs (Foreign Bank Account Reports). If your holdings in a foreign bank exceed $10,000 at any time during the tax year, you must file an electronic report with the Treasury Department. Once again, most banks have information-sharing agreements with the U.S. government, so strict compliance is important. Contact a certified tax coach near you to learn more about the implications of foreign income and foreign taxes.
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