Putting Foreign Taxes to Domestic Use

You diversified your portfolio to spread the risk and take advantage of that hot euro fund. That strategy also probably meant that you ended up paying foreign taxes on your investment.

But you can recoup that cost on your tax return. The Internal Revenue Service gives you two ways to use foreign taxes to your U.S. tax advantage.

Deducting Foreign Taxes

The first option is to use the foreign taxes as an itemized deduction. This means you'll have to file the long Form 1040 and associated Schedule A.

You'll find any foreign taxes paid on your investments in box 6 of the 1099-DIV you got from your investment manager. Enter that amount on line 8 of Schedule A, where it is included with other taxes you paid such as real estate or personal property assessments. Be sure to note on the dotted line that you're claiming the foreign taxes you paid.

Your foreign taxes will help increase your itemized deductions, which will lower your taxable income amount and ultimately produce a smaller tax bill.

Itemized deductions, however, aren't necessarily the best tax break. They cut your tax bill only incrementally based on your income tax bracket.

For example, if you're in the 25% tax bracket, your $100 foreign tax deduction is really worth only a $25 cut in your taxes. Plus, if you make a lot of money, the overall value of itemized deductions is reduced, making this tax break less favorable for some taxpayers.

Taking the Foreign Tax Credit

You might get a better tax break from the second way to write off these global taxes: the foreign tax credit.

Tax credits cut your tax bill dollar for dollar because you subtract them directly from the final tax you owe. That means a credit for $100 paid in foreign taxes will drop your $2,000 tax bill to $1,900. In most cases, it's to your advantage to claim your international tax payments as a foreign tax credit on your tax return.

Of course, as is often the case with taxes, it's not always that simple. The tax credit entry on Form 1040 line 47 instructs you to "Attach Form 1116 if required." Although only two pages, its 29 lines, plus additional alphabetical sublines, require detailed entries about your investment and taxes.

The instructions are no better, with references to foreign source gross income, currency conversions and foreign tax credit redeterminations. A quick look at Form 1116 is enough to make most taxpayers forget about the relative advantages of credits over deductions.

But don't despair yet! The IRS actually gives smaller international investors a break. Generally, if your foreign taxes are $300 or less (twice that for married couples filing jointly), you can ignore Form 1116.

You can find credit guidelines in the Form 1040 instructions or, if need be, more detailed information in Form 1116's directions. After checking both, if you find you qualify, enter your foreign tax amount on line 47 of your return, and you're done.

Check with your investment and tax advisers if you have any questions about whether you can claim the foreign tax credit. The IRS also covers this topic in Publication 514, Foreign Tax Credit for Individuals.