The Foreign Tax Credit

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In an increasingly global economy, chances are that if you invest in a large corporation or mutual fund, you may find that you have received income from a foreign source, and paid income taxes to a foreign government.

Good news: You may be able to claim the foreign tax that you paid as a deduction or credit on your U.S. income tax return.

To find out if you have paid any foreign income taxes, look at Forms 1099-DIV, 1099-INT, or your year-end broker's statement.

How to Claim the Foreign Tax

Generally, you can claim the foreign income tax paid as:

• An itemized deduction on Schedule A
  
• An income tax credit (generally the better approach)

In most cases, you cannot claim part of the foreign taxes as an itemized deduction and part as an income tax credit in the same year. You must use the same method to claim all of the qualified foreign taxes.

Claiming the Foreign Tax as an Itemized Deduction

You can claim any foreign tax paid as an itemized deduction on Schedule A.

This increases your itemized deductions and decreases your taxable income, which reduces your federal income tax bill. In a 15% tax bracket, you save $15 for every $100 of foreign tax paid.

Claiming the Foreign Tax as a Tax Credit

You can use certain foreign taxes paid to reduce your federal income tax bill on a dollar-for-dollar basis. Here is how:

• If you paid $300 or less in foreign taxes ($600 if married filing jointly) and your only foreign income came from interest and dividend income reported to you on a Form 1099-INT or 1099-DIV or similar statement.

• If you paid more than $300 in foreign taxes ($600 if married filing jointly), you can still claim a dollar-for-dollar credit, but the process is a bit more complex. Complete Form 1116, Foreign Tax Credit, and include it with your tax return. Claiming the foreign tax credit saves you $100 for every $100 of foreign tax paid. In a 15% tax bracket, that is $85 more than claiming the itemized deduction.

Other taxes, such as foreign real estate taxes and personal property taxes do not qualify. But you may be able to deduct these other taxes even if you claim the foreign tax credit for the foreign income taxes. You can deduct these other taxes if they are expenses you incurred carrying out a trade or business, or producing income. One wrinkle: If you had to pay foreign real estate tax, but they were not part of your business, you can deduct this tax as an itemized deduction on Schedule A.