By Bethany Bouw, CPA
There have been some rumblings recently about foreign taxes, specifically foreign real estate taxes. As one might imagine, there are a wide variety of foreign taxes. These foreign taxes can include items such as income taxes, real estate taxes, wealth taxes, estate taxes, solidarity taxes, and value-add taxes It can be easy to lump these all together when asked about foreign taxes paid or accrued if a taxpayer is not careful. Instead, it is best to be aware of the breakdown as not all foreign taxes are treated equally. Taxpayers should also be aware that there are limits on foreign taxes that would otherwise be creditable or deductible.
Foreign Real Estate Taxes
Schedule A of the Form 1040 used to include foreign real estate taxes in the taxes deducted. Unfortunately, with the recent tax reform, these may no longer be deducted on Schedule A (though for taxpayers already limited by the SALT cap with just domestic real estate and state income tax this is not as large of a loss). This disallowance means taxpayers without a state income tax and domestic real estate tax may find themselves unable to deduct much in the way of taxes on Schedule A.
However, there is a silver lining for individuals who meet the foreign earned income exclusion tests. Previously, if you had foreign real estate taxes, they could not be included in the foreign housing costs for foreign housing exclusion or deduction due to being allowed on Schedule A. While foreign real estate taxes are disallowed on Schedule A, foreign real estate taxes may be considered for the foreign housing exclusion or deduction, so all is not lost for those owning their residence abroad.
Foreign Tax Credit
Many taxpayers erroneously believe that all foreign taxes are creditable on Form 1116 Foreign Tax Credit. However, this is not the case as only taxes paid or accrued to a foreign country or US possession for income, war profits, and excess profits may be taken on the Form 1116. The taxes paid/accrued for income, war profits, and excess profits to subdivisions of foreign countries or US possessions, states, provinces, cities, counties, and the like may also be creditable. Taxes that are in lieu of tax on income, war profits, and excess profits may also be creditable. The limitation on the type of tax means that wealth taxes, estate taxes, solidarity taxes, social taxes, and value-add taxes are generally not creditable taxes.
Foreign taxes are also subject to being grouped categorically. This grouping means that foreign taxes on passive income are determined for credit purposes with only taxes on passive income. Taxes on general category income would be with general category. The groupings prevent misuse of the foreign tax credit. The foreign tax credit is designed to relieve US taxpayers from the burden of double taxation. Income that is earned abroad by a US citizen is likely reported on both the foreign tax returns and the US tax return. Without a mechanism to credit tax in one of the jurisdictions, the taxpayer could potentially be subject to tax from two nations on one income.
Based on the nature of the foreign tax credit, if income is excluded (say under a foreign earned income exclusion) or is reduced based on related expenses and deductions, the full income amount would not be eligible for a tax credit.
Maria is a US citizen who is working in Europe. She earns $120,000 in wage income for the year. Maria receives the full 2018 foreign earned income exclusion of $103,900 leaving $16,100 of unexcluded foreign wage income. If Maria was taxed at 20% in the European country she worked in, they taxed her $120,000 wages at $24,000. Since only $16,100 of that income is subject to double taxation, she would not be able to consider the whole $24,000 of foreign income tax as creditable. Only the tax on the portion of income that is double taxed would be potentially creditable.
If the tax is not ultimately owed to the foreign country or US possession through credit, treaty, or residency – the tax is not creditable even if paid. Additionally, if the income is subject to beneficial rates, such as dividends under a tax treaty, they are adjusted in the foreign tax credit to represent the favorable tax treatment. If there is tax potentially creditable but there is no tax liability in the current year, there are two ways to utilize the foreign tax credit:
- Carryback foreign tax credit one year and then carryover up to 10 years
- This method would make sense if you had more ability to take the credit in the prior year than there were foreign taxes available for the credit.
- Elect out of carryback and simply carryover up to 10 years
The International Tax Team at Ryan & Wetmore is well-versed in reporting of foreign taxes and complicated foreign tax matters. For questions or concerns regarding your international accounts, entities, and assets click here to email our foreign tax team. Please be aware that tax issues are complicated and may vary based on the details of your situation. For this reason, an initial phone call is generally required to obtain the facts and address the questions.
Bethany Bouw CPA, is a manager at Ryan & Wetmore and has been with the firm for over eight years. She has experience with offshore voluntary compliance and assisting taxpayers with foreign asset and entity reporting requirements.
Traci Getz CPA, is a partner with Ryan & Wetmore, P.C. Traci has over fifteen years of experience providing accounting, tax, and consulting services to small and medium-sized business owners. She works with clients to understand their accounting and tax issues while specializing in international tax, healthcare, and construction.
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