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What is the difference between foreign tax credit and deduction?

Article ID: 50
Last updated: 12 Nov, 2014
Revision: 5
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By Jason Watson ()

The IRS allows you to take a credit for foreign taxes paid which reduces your tax liability, or allows you to take a deduction which reduces your taxable income. You must treat all foreign income taxes the same way- if you take a credit for any foreign taxes, you cannot deduct any foreign income taxes. However, you may be able to still deduct some foreign taxes while you take the credit for foreign taxes paid (some unique situations).

There is no hard and fast rule on whether to take the credit or the deduction, but generally speaking the credit is going to be to your advantage since it reduces tax liability (versus taxable income whose benefit is only as good as your income tax bracket). Having said that there are some narrow scenarios where taking a deduction rather than a credit would be better (rare, as in super rare).

Lastly, you cannot take a credit or deduction for any foreign taxes paid on earnings in which you excluded through the foreign earned income exclusion or housing exclusion / deduction. However, if you have foreign taxes associated with earnings that were not excluded you may take a pro-rated credit or a deduction. For example, let’s say you earned $150,000 of foreign income and you paid $20,000 in foreign taxes on that income. The full foreign earned income exclusion of $99,200 (in 2014) represents about 66.13% of your total income. Therefore, the first 66.13% of your $20,000 in foreign taxes is ineligible for credit or deduction, but the remainder ($6,774 in this example) is allowed.

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Also read
item What is foreign earned income exclusion?
item What is considered foreign earned income?
item How do moving expenses affect my exclusion?
item What happens if my host country has a form of social security?
item Are there any downsides to claiming the foreign earned income exclusion?

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