How to Claim the Foreign Tax Credit and Avoid Double Taxation on Foreign Income

Think paying taxes once is frustrating? Try paying them twice. At InvestoDock, we know how confusing foreign taxes can get—especially when it comes to foreign income. Many Americans don’t realize they may qualify for the foreign tax credit, which can significantly reduce their U.S. tax bill. In this guide, we’ll walk you through everything you need to know to keep more of your global income—clearly, simply, and without the stress.

What Is the Foreign Tax Credit?

In-depth explanation

When I first started freelancing for international clients, I thought getting paid in different currencies was the cool part—until tax season came around. That’s when I met my first real headache: foreign income. I quickly realized that while the money felt like a bonus, Uncle Sam still wanted his share—even if taxes were already paid abroad.

That’s where the foreign tax credit saved me. In simple terms, it’s a U.S. tax credit that reduces your U.S. tax liability by the amount of foreign income tax you’ve already paid. Without it, you’d essentially be taxed twice for the same income—once by the foreign country and again by the U.S. government.

Here’s the kicker: not every foreign tax qualifies. The IRS only allows credits for income taxes (or taxes similar to them). Plus, you can’t claim a credit if you’re also deducting those same taxes—it’s one or the other.

It’s also not a dollar-for-dollar refund. There’s a calculation involved based on how much of your income is considered foreign versus domestic. Yeah, math again.

Legal basis and relevance for U.S. citizens and residents

The foreign tax credit is grounded in Section 901 of the U.S. Internal Revenue Code. This legal provision is specifically designed to protect U.S. taxpayers—both citizens and residents—from double taxation on foreign income.

It’s particularly relevant if you:

• Work abroad or own a business in another country
• Have investments in foreign stocks that withhold taxes
• Receive income from foreign clients or rental properties

The form you’ll get very familiar with? Form 1116. It’s your go-to when claiming the credit. It might look scary at first, but once you understand how the credit works, it feels like a shield protecting you from paying taxes twice.

“In this world nothing can be said to be certain, except death and taxes.” – Benjamin Franklin. True, but at least we can lower one of them.

Who Qualifies for the Foreign Tax Credit?

Eligibility criteria

The first time I heard about the foreign tax credit, I thought, “Great, maybe I can get some of my taxes back.” But of course, it’s not that simple. The IRS loves rules, and this credit has plenty.

To qualify, you must:

• Be a U.S. citizen or resident alien for the entire tax year.
• Have foreign income that’s been taxed by a foreign country.
• Have actually paid or accrued that foreign tax.
• Have the legal liability for that tax. (In other words, someone else can’t have paid it for you.)

And you can’t use the credit if the income was exempt from U.S. tax under a tax treaty. Oh, and if you’re claiming the foreign earned income exclusion (Form 2555), you can’t double dip and use the same income for the credit.

Types of income covered

Not all income qualifies, but here’s what usually does:

• Wages earned abroad
• Interest or dividends from foreign investments
• Royalties from international licensing
• Rental income from overseas properties

The IRS is strict about this: the income must be earned in another country and taxed by that country.

Countries included/excluded

Most foreign countries are fair game, but not all. The U.S. excludes countries with which it doesn’t maintain diplomatic relations or that support terrorism (think North Korea, Iran, etc.).

Pro tip? Always check the current IRS list before assuming your foreign income is eligible. A surprise at tax time is never fun.

Lesson learned: Just because you earned it abroad doesn’t mean the IRS won’t want to talk about it.

How the Foreign Tax Credit Works

Basic mechanics

I’ll be honest—when I first saw Form 1116, I stared at it like it was written in hieroglyphics. But once I got the basics of how the foreign tax credit works, it started making sense (sort of).

The whole idea is to prevent you from being taxed twice on the same foreign income. The IRS lets you subtract the taxes you paid to a foreign country from your U.S. tax bill—up to the amount you would’ve paid if the income were earned in the U.S.

But it’s not a full refund. There’s a formula involved:

• Find the portion of your total income that is foreign.
• Multiply your U.S. tax bill by the ratio of foreign income to total income.
• That’s the maximum credit you can take.

So if your foreign tax is more than that limit, the extra doesn’t count—unless you carry it over to future years.

Examples of double taxation scenarios

Here’s what happened to me: I earned $5,000 from a UK-based client and paid about $1,000 in UK taxes on it. Come tax time in the U.S., the IRS also wanted to tax that $5,000. That’s double taxation. Thankfully, with the foreign tax credit, I offset most of what I owed to the IRS.

Another case? Let’s say you get dividends from a Canadian company and they withhold 15% at source. That’s tax paid to Canada. The U.S. still counts it as income, but with the credit, you can reduce your U.S. tax liability by the amount already paid.

Interaction with the Foreign Earned Income Exclusion

Now here’s where things get tricky. If you use the foreign earned income exclusion (Form 2555) to exclude a portion of your foreign income, you can’t use that same income to claim the foreign tax credit. No double dipping!

It’s one or the other. Some people split it—exclude part of the income, then take the credit on the rest. But that takes careful planning (or a really good accountant).

“You must pay taxes. But there’s no law that says you gotta leave a tip.” – Morgan Stanley

Credit vs. Deduction: Which Should You Choose?

Pros and cons of each option

Back when I first started dealing with foreign income, I had no idea whether to take a foreign tax credit or just deduct the taxes. I thought, “A deduction is good, right?” But then I found out the credit can sometimes save way more money.

Here’s the deal:

• Credit: Reduces your tax bill dollar-for-dollar. If you owe $2,000 and have a $500 credit, you only pay $1,500.
• Deduction: Lowers your taxable income. If you’re in the 22% tax bracket, a $500 deduction saves you $110 in taxes.

So yeah, in most cases, the foreign tax credit wins.

When to choose credit over deduction

If you’ve paid taxes to a foreign country on foreign income and you’re eligible, choosing the credit usually gives you a bigger tax break. Especially if the tax rate abroad is high. But if you’re not eligible for the credit—maybe due to IRS limits or because the taxes aren’t recognized—then the deduction might be your only option.

IRS recommendations

The IRS actually recommends taking the foreign tax credit over a deduction in most cases, especially if the foreign taxes are significant. They even make it the default method on Form 1040. But as always, it depends on your unique situation.

“A tax loophole is something that benefits the other guy. If it benefits you, it’s a tax break.” – Russell B. Long

Watch also: How to Avoid Capital Gains Tax When Selling Your Home: Full Guide for Homeowners

How to Claim the Foreign Tax Credit (Step-by-Step)

Forms required (Form 1116, IRS Schedule 3, Form 1040)

Claiming the foreign tax credit the first time felt like assembling IKEA furniture—confusing instructions and missing screws. But once you understand the flow, it’s manageable.

Here’s what you’ll need:

1. Form 1116: This is where the magic happens. You’ll list your foreign income, foreign taxes paid, and do the math to calculate the credit.
2. Schedule 3 (Form 1040): This is where the credit amount from Form 1116 gets reported.
3. Form 1040: Your main U.S. income tax return. It all ties back to this form.

If you paid $300 or less in foreign taxes (or $600 for married filing jointly) and meet certain requirements, you might not need Form 1116. But check the IRS rules carefully.

Common mistakes to avoid

Here’s where I nearly messed up:

• Using excluded income: Don’t include foreign income you already excluded under the foreign earned income exclusion. The IRS won’t let you double benefit.
• Missing exchange rates: All amounts must be converted to U.S. dollars using proper exchange rates for the year taxes were paid.
• Not allocating taxes correctly: If you paid taxes to more than one country, you must separate each amount and tie it to the specific income.

Many people also forget carryovers. If your credit is more than your U.S. tax owed, you may be able to carry the extra forward for up to 10 years or back for one year.

Documentation you’ll need

Keep every receipt and tax notice you get from the foreign country. The IRS doesn’t ask for these when you file, but if they audit you, you’ll need proof.

You should have:

• Foreign tax returns or payment receipts
• Proof of foreign income earned (invoices, pay stubs, contracts)
• Exchange rate documentation

“The hardest thing in the world to understand is income tax.” – Albert Einstein. And that guy was a genius.

Understanding Carryovers and Carrybacks

What to do with unused credit

So you did all the work, filled out Form 1116, and bam—you have more foreign tax credit than you can use this year. Annoying? A little. Wasted? Not at all.

The IRS actually lets you carry back unused credits to the previous year, or carry them forward for up to 10 years. That means if you paid a lot of foreign taxes this year but didn’t owe much U.S. tax, you’re not losing that benefit—it’s just waiting for the right year.

Just make sure you didn’t already max out your credit last year if you’re thinking of a carryback. And yes, it takes some paperwork.

How to apply carryovers to future years

To use a carryover, you’ll need to file Form 1116 in the year you want to apply it, and include a record of when and how the unused credit was originally earned.

Keep a clear record of:

• The year the excess credit was created
• The amount of unused foreign tax credit
• The type of foreign income it came from

If it sounds complex—it is. But it’s also free money, and it can really cut your tax bill in future years.

Think of carryovers like leftovers from dinner—just as good later, if not better.

Foreign Tax Credit Limitations and Exceptions

Limitations by country, income type

Here’s the truth: the foreign tax credit isn’t always a slam dunk. The IRS has rules—lots of them—about when and how much credit you can actually claim.

First off, the credit only applies to income taxes paid to foreign countries that are recognized by the U.S. That means if you paid taxes to a country under sanctions or one that the U.S. doesn’t have diplomatic relations with, tough luck—no credit allowed.

Also, not all types of foreign income qualify equally. Passive income (like interest or dividends) might be subject to additional restrictions, especially if the foreign tax rate was higher than what the IRS considers normal. There’s even something called “high-tax kickout rules” that might come into play.

Excluded income (e.g. income under Form 2555)

This is where I almost tripped up: if you use Form 2555 to exclude foreign earned income from your U.S. taxes, you can’t use that same income to claim the foreign tax credit. The IRS doesn’t let you “double dip.”

So, if you exclude $100,000 of income using the foreign earned income exclusion, that $100,000 is off-limits when calculating your credit.

Situations where credit may not be allowed

In addition to sanctioned countries or excluded income, there are other cases where the credit may be denied:

• Taxes that aren’t considered income taxes (like value-added tax or property tax)
• Taxes paid on income that’s not taxed by the U.S.
• Taxes refunded by the foreign country

The key takeaway? Always double-check before claiming. Just because you paid it doesn’t mean it’s credit-worthy in the eyes of the IRS.

The IRS motto might as well be: “If in doubt, you owe.”

What About FBAR, FATCA, and Other Reporting Obligations?

How they relate to the FTC

Here’s the part no one tells you: claiming the foreign tax credit doesn’t mean you’re off the hook for other reporting. In fact, having foreign income usually means you have more paperwork to do, not less.

Just because you filed Form 1116 doesn’t mean the IRS knows about your foreign bank accounts or assets. That’s where FBAR and FATCA come in.

Summary of additional forms (FBAR, Form 8938)

FBAR (Foreign Bank Account Report): If you had $10,000 or more in foreign accounts at any time during the year, you must file FinCEN Form 114. This goes to the Treasury Department—not the IRS—but they definitely talk to each other.

Form 8938: Required under FATCA, this form must be filed with your tax return if your foreign assets exceed certain thresholds (which vary by filing status and residency).

Consequences of non-compliance

Skipping these forms can be a disaster. We’re talking massive penalties—up to $10,000 per violation, and even criminal charges in serious cases. I’ve seen people ignore this part and regret it big time.

So yes, the foreign tax credit is great, but don’t forget the reporting side of the game. Because with the IRS, silence is not golden—it’s suspicious.

“It’s not the taxes that hurt, it’s the penalties.” – Every expat ever.

Tax Treaties and the Foreign Tax Credit

Overview of relevant treaties

Many people don’t realize that the U.S. has income tax treaties with over 60 countries. These agreements are designed to prevent double taxation and clarify which country has the right to tax specific types of foreign income.

While these treaties don’t replace the foreign tax credit, they can impact how much credit you’re eligible to claim—or whether you even need it in some cases.

How they impact credit eligibility

Some treaties allow for reduced tax rates on certain types of income, like dividends or royalties. Others may assign exclusive taxing rights to one country. If a treaty says a type of income is taxable only in the U.S., and you still pay tax abroad, you likely won’t get a credit for it.

The IRS publishes detailed treaty tables, and you should always review them if you’re earning foreign income in a country with an existing agreement. A little reading now can save a lot of tax pain later.

Treaties are like traffic signs: follow them and you’ll avoid trouble.

Watch also: Do You Pay Taxes on Game Show Winnings? What Every Winner Must Know

When to Consult a Tax Professional

Complex situations

If your tax situation involves multiple countries, different currencies, or income from several foreign sources—do yourself a favor and talk to a pro. The foreign tax credit can get complicated fast, especially if you’re also dealing with exclusions, tax treaties, or foreign corporations.

I once tried to file it all myself—big mistake. Between exchange rate rules, carryover limits, and FBAR deadlines, I was drowning. A tax professional helped me clean it up, and I ended up saving more than I paid in fees.

Benefits of using a qualified tax pro

Here’s what a good tax pro can do:

• Make sure you’re maximizing your foreign tax credit
• Help you avoid penalties tied to foreign income reporting
• Ensure you comply with FBAR, FATCA, and treaty requirements

They know the forms, the rules, and the loopholes—and can protect you from costly mistakes. Even one consultation can be a smart investment if your finances span borders.

“It’s not what you make, it’s what you keep that counts.” – Old tax wisdom

Conclusion

Navigating foreign income and the foreign tax credit isn’t always easy—but it’s definitely worth the effort. We’ve covered who qualifies, how to claim it, what forms to file, and when to seek help.

The key takeaway? Proper filing protects you from double taxation and costly penalties. Whether you’re a freelancer working abroad, an investor in foreign markets, or just earning income outside the U.S., understanding these rules can save you thousands.

Need more info? Check out the IRS Foreign Tax Credit page or talk to a qualified tax advisor who knows international tax inside and out.

File smart. Stay compliant. Keep more of your money.

Being proactive about taxes isn’t just smart—it’s profitable.

Frequently Asked Questions

What is the foreign tax credit?

The foreign tax credit is a U.S. federal tax benefit that allows you to reduce your U.S. tax liability by the amount of income taxes you’ve already paid to a foreign country. It’s designed to prevent double taxation on foreign income.

What is the foreign tax credit for 2025?

The rules for the foreign tax credit in 2025 remain consistent with prior years: it applies to income taxes paid to a foreign country or U.S. possession. You typically claim it using Form 1116. However, some thresholds or exchange rate policies may vary—check the latest IRS updates for 2025-specific details.

Can I claim foreign tax credit without filing Form 1116?

Yes, in limited cases. If you paid $300 or less in foreign taxes ($600 if married filing jointly) and meet certain simple filing conditions, you may claim the foreign tax credit directly on Schedule 3 without Form 1116. For larger or more complex foreign taxes, Form 1116 is required.

Which states allow foreign tax credits?

Most states do not allow a foreign tax credit for state income tax purposes. However, a few exceptions exist—California, for example, has no foreign tax credit, while states like New Mexico or Hawaii may have limited versions. You should check with your state’s tax authority or a local tax professional to be sure.