Don't think that the foreign tax credit would ever apply to you? Think again. Even if you never travel beyond the borders of the good old U. S. of A., you may still get hit with a foreign tax. How? Well, perhaps on foreign investments such as stock, mutual funds, or partnership interests. With such investments, foreign taxes may have been paid on your behalf as a shareholder.

If you do get hit with foreign tax (usually withheld by the source country from your interest, dividends, or partnership distributions), what can you do? Well, you can either claim the foreign tax as a credit against your U.S. income tax, or you can take a deduction for the foreign taxes paid as an itemized deduction on your Schedule A. But you can't do both for the same foreign taxes paid.

Generally, the credit saves you more tax dollars, but the Schedule A deduction is allowed for certain taxes that don't qualify for the foreign tax credit due to boycott provisions or other limitations provided by the Internal Revenue Code. So, don't be afraid to figure your taxes both ways and elect the treatment that saves you the largest amount of U.S. tax.

In the not-too-distant past, computing and reporting the foreign tax credit was a monumental pain in the pencil. You were required to file IRS Form 1116, prepare a number of computations and calculations, and attach Form 1116 to your tax return. But no longer. If you qualify, you can simply report the foreign tax directly on Form 1040 (but only Form 1040, not Form 1040EZ or 1040A) in the credit section on page 2. Because of this change, taking the credit has never been easier.

You are allowed to bypass Form 1116 and report your foreign tax credit directly on Form 1040 if:

• Your total foreign taxes paid during the year don't exceed $300 for a single filer, and $600 for a married-joint filer.
• All of your foreign income is from "passive" sources, such as interest, dividends, annuities, rents, or royalties. The foreign income can't be from an active trade or business.
• All of the foreign income is reported on Form 1099DIV, 1099INT, or other similar statements.
• Foreign taxes from the current year can't be carried forward to any other tax year, and foreign taxes from any other years can't be carried forward to the current year.

If you pay foreign taxes, you can read more about how to claim the foreign tax credit or the deduction for foreign taxes on Schedule A by reading IRS Publication 514. Form 1116 and its instructions (which you can select and download from the IRS website here) will also give you substantial information on how to compute and report the credit on your 1040, so it's useful even if you don't have to file it with your return.

Related Links:
IRS Publication 514
20 Foolish Tax Tips

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March 8, 2002

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