The foreign tax credit is one of three forms of relief from double taxation available if you pay income taxes to a foreign government. The others are the foreign earned income exclusion, which you might use if you worked abroad, and an itemized deduction on Schedule A. It may be the most valuable as well, since it can reduce your U.S. tax, dollar-for-dollar, by the amount of tax you paid in another country. But it can also be the most difficult to claim because, in an attempt to make sure no one gets more credit than is deserved, Congress and the IRS have teamed up to create one of the most diabolically complex tax forms in the book.
Fortunately, if the only foreign taxes you paid were reported on a 1099 or Schedule K-1, and if the amount is under $300 ($600 if married filing a joint return), you don't need to complete Form 1116. Instead, you can claim the foreign tax credit right on Form 1040.
The IRS asks you to use a different Form 1116 for each type of income on which you paid foreign tax. There are ten categories, but you are most likely to encounter just three of them: passive income (interest, dividends, capital gains, etc.), high withholding tax interest (foreign interest subject to foreign withholding tax of 5% or more) and so-called "general limitation" income (wages and other income not in any of the other seven categories).
This tongue- and brain-twisting concept would be enough to make even the most penny-pinching taxpayer flee to Schedule A. The idea is that, when you fill in your expenses in Part I, if any of them is an itemized deduction and you are a high-income taxpayer subject to the phase-out of itemized deductions, you need to adjust the expenses you enter in Part I accordingly. We figure out the formula for you below line 1a.
The Itemized Deduction Reduction Percentage comes into play for line 2. On line b of the mini-worksheet, enter your definitely related expenses that are subject to the itemized deduction reduction. This includes itemized expenses, other than medical expenses, interest, casualty/theft losses and gambling losses, that definitely relate to the foreign income in each column. Most people will just enter the state and local income taxes they paid on the foreign income. (See Pub. 514 for details.)
We also use the Itemized Deduction Reduction Percentage for line 3a . Don't be overwhelmed by the mini-worksheet; you might not have to make any entries. From Schedule A, we carry any real estate taxes to the first line. On the next line, enter any gifts to charity from line 18 of Schedule A that you made before July 28, 2004, unless you elect to omit them (see the IRS instructions for details). On the next line, we carry general sales taxes from Schedule A. On the next line, enter any other expenses from Schedule A that don't definitely relate to any of your income, but don't count any medical expenses, interest, casualty/theft losses or gambling losses. Next, we add lines a - d together and apply the reduction formula.
We then carry your medical expense deduction from Schedule A to the mini-worksheet, line 3g. Enter any casualty/theft losses or gambling losses that don't definitely relate to any of your income on line 3h of the mini-worksheet.
If you did not itemize, we carry your standard deduction to the mini-worksheet.
The bottom line of the mini-worksheet is either your standard deduction or the total of the itemized deductions in the mini-worksheet.
To figure total foreign income for each column, we start with the gross income from sources in the country from line 1a. Then we leave an entry for you to enter the amount of foreign earned income from that country excluded on Form 2555 or 2555-EZ. We blank out the entry for foreign earned income excluded on Form 2555 or 2555-EZ if you checked passive income or high withholding interest at the top of Form 1116.
Your gross income is computed as follows:
1040 Total Income
- 1040 line 12 (Schedule C net income)
- 1040 line 13 (capital gain/loss)
- 1040 line 17 (Schedule E net income)
- 1040 line 18 (Schedule F net income)
+ Schedule C Gross Profit
+ Schedule C-EZ Gross Receipts
+ Schedule D, line 7 + line 16
+ Schedule E Total Royalty
+ Schedule E Total Rent
+ Schedule F Gross Income
+ Form 4835 Gross Rents
+ Foreign Earned Income
Special rules govern the allocation of your interest expenses to your foreign income. We use the data in your return to compute your allocable mortgage interest expense. We display this calculation for you in the mini-worksheet above line 4a. If you have investment or other interest expenses to allocate, please follow the directions for line 4b in the IRS instructions.
There is a special computation for this line if we figured your tax using the maximum capital gains rates. The computation is carried out for you in the mini-worksheet above line 17.
On the Alternative Minimum Tax version of this form, line 19 is carried from Form 6251 line 31.