Form 1116 Foreign Tax Credit: Limit, Categories and Carryovers

Why is my foreign tax credit limited on Form 1116?

The credit can only cancel US tax on your foreign income, never more, so Form 1116 caps it at:

US tax × (foreign-source taxable income in the category ÷ worldwide taxable income)

The credit is the smaller of that limit or the qualifying foreign tax, figured separately for each income category (26 U.S.C. 904(a); Publication 514). Foreign tax above the limit is not lost at once: it can carry back 1 year and forward 10 years, but only into years with spare room in the same category, and then it expires.

Two other adjustments: the deduction for people 65 and older (Schedule 1-A) is kept out of the fraction for the years it is in effect, and the limit applies to regular income tax, not the net investment income tax (Form 1116 instructions).

A case stops being simple when you have income in more than one category, carryovers from past years (especially ones left off a return), an accrual election, alternative minimum tax, income excluded on Form 2555, or a treaty that re-sources income (treats US-source income as foreign). Gather your foreign tax returns and assessments with payment dates, pay slips, broker statements, every prior Form 1116 and Schedule B (Form 1116), and any foreign refund notices.

Whether to use the credit or the exclusion is covered in FEIE or foreign tax credit. If you live in the US, claiming small amounts without Form 1116, or deducting foreign tax instead, is covered in foreign income on a US return.

Passive vs general category income: which goes where?

Investment income goes in the passive category (often called the passive basket); pay and business income go in the general category (the general basket). Each category gets its own Form 1116, its own limit and its own carryover (Form 1116 instructions).

High-taxed passive income moves to general. Passive income is high-taxed when the foreign tax on it, after expenses, is more than the top US rate (37%) times the income. That income and its tax then go on the general category form (26 CFR 1.904-4(c); 26 U.S.C. 904(d)(2)(F)). Items are tested in four groups, not one by one: income with withholding tax of 15% or more, income with lower withholding, income with no foreign tax, and income taxed abroad other than by withholding (26 CFR 1.904-4(c)(3)).

Treaty re-sourcing. If a treaty treats US-source income as foreign and you claim that benefit, the income gets its own limit, and you may have to disclose the position on Form 8833; the penalty for leaving it off is $1,000 (Form 1116 instructions; Publication 514). That rule does not apply to re-sourcing under a treaty's special relief article for US citizens living in the other country, which needs no Form 8833 (Publication 514). Canadian residents' US dividends follow why you still owe the IRS after paying Canadian tax.

I live abroad and sell US stocks or funds: is the gain foreign or US source?

A gain from selling stocks or funds while living abroad is foreign source only if the foreign country collected income tax of at least 10% of the gain. Such a gain generally follows the seller's residence, under a special definition: a US citizen or resident with a foreign tax home counts as a nonresident only when that much foreign tax is actually paid (26 U.S.C. 865(g); Publication 514).

Your tax home is generally where your main place of work is (Form 1116 instructions). Inventory, business property and sales through a foreign office follow other rules. A treaty with the country you live in may change the result; check it before filing.

Which foreign payments count: National Insurance, social security, CSG, treaty-rate withholding?

Only a foreign income tax that is imposed on you, actually owed and paid counts. Four tests must be met: the tax is imposed on you, you paid or accrued it, it is your legal and actual liability, and it is an income tax or a tax in place of one (IRS: foreign taxes that qualify).

So UK National Insurance, Spanish social security and Canada Pension Plan contributions, which those agreements cover, are not creditable. For a country with no agreement, a social tax funding pensions, unemployment or health benefits is not treated as payment for a benefit if the amount does not depend on your age or life expectancy, but it must still meet the income-tax rules (Publication 514). Final regulations (Treasury Decision 9959) tightened those rules, and Notices 2023-55 and 2023-80 let taxpayers apply the older rules until further notice (Publication 514). Whether a given levy qualifies is unsettled for many countries and needs a case-by-case review. The IRS statement on CSG and CRDS addresses only the agreement question; the levies must still be income taxes.

When pay is only partly excluded, the tax on the excluded share is cut out by a fraction (Publication 514). Social security coverage and certificates are covered in self-employment tax abroad; pensions in foreign pension reporting.

My foreign tax year ends in April (UK): paid or accrued, and which US year?

By default you claim foreign tax in the US year you pay it, not the foreign year it belongs to. Tax withheld from pay is generally treated as paid when withheld; a balancing payment counts in the year you send it (Publication 514).

You can instead elect to claim tax when it accrues, by checking "Accrued" in Part II of Form 1116 on a timely filed original return. Accrued tax generally belongs to the US year in which the foreign tax year ends; a final withholding tax, such as on dividends, accrues on the day it is withheld. The election binds every later year. It cannot be made on an amended return unless that year is the first year you ever claim the credit; then an amended return within the 10-year period for choosing the credit also works (Form 1116 instructions; 26 CFR 1.905-1(d), (e)).

In the year you switch to accrued, you may claim both last year's tax paid this year and this year's accrued tax.

With an April year, the foreign tax on pay from April to December accrues in the next US year, while that pay is reported in the first. The carryback and carryforward exist to even out mismatches like this. Accrued tax not paid within 24 months after the year it relates to must be taken back out of the credit, and a later foreign refund or extra assessment means refiguring the year (Publication 514). Fixing the US return after a foreign change is covered in amending after the other country changes your return.

Foreign tax credit carryover: how do one year back and ten forward work?

Unused foreign tax in a category is applied first to the year before (1 year), then forward (10 years) year by year in order, but only up to each year's spare room in the same category (26 U.S.C. 904(c); 26 CFR 1.904-2).

• Unused foreign tax: foreign tax in a category above that year's limit.
• Spare room (excess limit): the limit in a later or earlier year above the foreign tax actually paid that year.
• Order: oldest carryover first; each year's room absorbs as much as it can.
• Expiry: what is left at the end of the carryforward period is lost. The period is not extended for a year in which the credit could not be used.

A carryover cannot reduce US tax on US-source income or on another category's income, because every year's credit is capped at the US tax on that category's foreign income. In a high-tax country, wages rarely create spare room, so general-category carryovers often expire unless you later have foreign income taxed more lightly, for example after moving to a lower-tax country.

You cannot carry unused tax out of a year in which you deducted foreign tax. A year in which you deduct foreign tax still uses up carryovers to the extent of its room, with no benefit unless you amend that year to the credit within 10 years of its regular due date, and a year in which you claim the credit without Form 1116 ($300, or $600 on a joint return) cannot send or receive carryovers (Publication 514). Joint and separate returns in different years can require an allocation between spouses.

Do I have to file Schedule B (Form 1116) every year? What if I left a carryover off?

File Schedule B for a category every year that category has a foreign tax carryover in the prior year, the current year, or both. It reconciles the running balance year by year and feeds Form 1116, line 10 (Schedule B instructions; Form 1116 instructions). You do not need it for a year that only receives a carryback.

A carryover left off a past return is not simply waiting for you. The law treats carried tax as used in each year that had spare room, whether you claimed it or not (26 U.S.C. 904(c); 26 CFR 1.904-2(d)). To get the benefit, amend that year with a revised Form 1116, then correct the balance carried into the following Schedules B. A claim that increases the credit has a special period of 10 years from the regular due date of the return for the year the foreign tax was actually paid or accrued (Publication 514). Rebuilding several years of balances is where most errors happen.

How do I amend a prior year to use a foreign tax credit carryback, and by when?

File Form 1040-X for the year before the excess year, with a revised Form 1116 showing the carryback on line 10 (Publication 514; Form 1116 instructions). That earlier year must have spare room in the same category.

The deadline is 10 years from the regular due date, without extensions, of the return for the year the foreign tax was actually paid or accrued, not the earlier year being amended. The general window, 3 years after filing the original return or 2 years after paying the tax, whichever is later, does not limit a claim based on the credit (Publication 514). In exchange, the IRS can assess tax from a carryback until one year after the assessment period for the excess year ends.

When do I need the AMT version of Form 1116?

Only when alternative minimum tax may apply. If Form 6251, line 10 (regular tax less the foreign tax credit), is at least the AMT before its foreign tax credit on line 7, you owe no AMT and leave the AMT credit line blank, though you still figure it for your records if an unused AMT credit could carry to another year (Form 6251 instructions).

If AMT may apply, figure the AMT foreign tax credit on a separate Form 1116 for each category, marked "AMT", using AMT income and deductions. On these forms, use the AMT rate, not the regular top rate, to decide whether passive income is high-taxed. It has its own carryover, which can differ from the regular one. Attach the AMT forms only if the AMT credit differs from the regular credit. A simplified limitation election lets the AMT form reuse regular foreign-source income, but it must be made in the first year you claim the AMT credit and binds later years (Form 6251 instructions). Stock option exercises are a common trigger; see AMT on incentive stock options.

Example

These examples are illustrative, use US dollars and round numbers, and show direction rather than exact tax.

Teacher in Spain, year by year

A US citizen moves to Spain in Year 2, teaches, earns US$50,000 a year, pays US$9,000 of Spanish income tax and takes the credit. Assume the US tax on that pay is US$6,000.

• Year 1: she lives in the US with no foreign income, so there is no room for a carryback.
• Year 2: credit US$6,000; unused US$3,000 in the general category. Nothing can go back to Year 1.
• Years 3 to 7: the same facts repeat, so each year adds its own US$3,000 of unused tax, with its own clock, and none is absorbed.
• Year 8: she moves to a country with lower tax; her general limit is US$5,000 against US$2,000 of local tax, leaving US$3,000 of room. The oldest carryover, from Year 2, is used in full; the later years' amounts wait.
• Had no room appeared by the end of Year 12, the Year 2 amount would have expired. Her Spanish social security, which the agreement covers, does not enter the credit.

US citizen in the UK sells US index funds

He sells US index funds for a US$20,000 gain and pays US$4,000 of UK tax on it, which is at least 10% of the gain, so the gain is foreign source and passive. The UK tax is below the top US rate times the gain, so the high-tax rule does not move it to general. Assume the US tax on that gain is US$3,000. The credit is then limited to US$3,000 and US$1,000 carries in the passive category. Had the UK tax been under 10% of the gain, the gain would be US source under the Code. As a UK resident, he could then use the US-UK treaty's relief article for US citizens, which treats the gain as UK source to the extent needed to credit the UK tax, still in the passive category and with no Form 8833 (Publication 514; US-UK treaty, Article 24(6)).

Manager in Singapore excludes all pay

She excludes her whole US$120,000 salary on Form 2555 and pays US$12,000 of local tax. None of that tax is creditable or carried forward. Switching to the credit in a later year does not bring it back. Revoking the exclusion for that year could make the tax creditable, up to the limit, but revoking has its own consequences, covered in FEIE or foreign tax credit.

Different for you?

• You are choosing between the exclusion and the credit, or want to switch: see FEIE or foreign tax credit.
• You have only passive income reported on payee statements and no more than $300 of foreign tax, or you live in the US with income from abroad: see foreign income on a US return.
• You live in Canada and still owe on US investments: see why you still owe the IRS after paying Canadian tax.
• The foreign country changed or refunded your tax after you filed: see amending after the other country changes your return.
• You pay social security abroad or need a coverage certificate: see self-employment tax abroad.
• Your foreign income is a pension or from funds bought abroad: see foreign pension reporting and funds bought outside the US.
• You missed carryovers across several years, owe AMT, or have income in several categories: get cross-border tax help.
• You are not sure you must file from abroad at all: see filing while living abroad.