Understanding Taxation of Foreign Investments (2024)

For many of today's investors, diversification goes beyond owning companies in a variety of industries—it means adding securities from different parts of the globe, too. In fact, many wealth management experts recommend diverting a third or more of one's stock allocation into foreign enterprises to create a more efficient portfolio.

But if you’re not aware of the tax treatment of international securities, you're not maximizing your true earnings potential. When Americans buy stocks or bonds from a company based overseas, any investment income (interest, dividends) and capital gains are subject to U.S. income tax. Here's the kicker: The government of the firm's home country may also take a slice.

If double taxation sounds draconian, take heart. The U.S. tax code offers something called the "foreign tax credit." Fortunately, this allows you to use all—or at least some—of those foreign taxes to offset your liability to Uncle Sam.

Key Takeaways

  • When Americans buy stocks or bonds from foreign-based companies, any investment income (interest, dividends) and capital gains are subject to U.S. income tax and taxes levied by the company's home country.
  • The U.S. tax code offers the “foreign tax credit," which allows foreign taxes to offset some of your liability to Uncle Sam.
  • With the foreign tax credit, for any "qualified foreign taxes" you've paid, such as income, dividends, and interest, you can claim a tax credit or a deduction (for those who itemize) on your tax return.

Basics of the Foreign Tax Credit

Every country has its own tax laws, and they can vary dramatically from one government to the next. Many countries have no capital gains tax at all or waive it for foreign investors. But plenty do. Italy, for example, takes 26% of whatever proceeds a non-resident makes from selling their stock. Spain withholds 19% of such gains. The tax treatment of dividend and interest income runs the gamut as well.

While it doesn't hurt to research tax rates prior to making an investment—especially if you're buying individual stocks and bonds—the IRS offers a way to avoid double taxation anyway. For any "qualified foreign taxes" that you've paid—and this includes taxes on income, dividends, and interest—you can claim either a tax credit or a deduction (if you itemize) on your tax return.

So how do you even know if you've paid foreign tax? If you have any holdings abroad, you should receive either a 1099-DIV or 1099-INT payee statement at year’s end. These forms will show how much of your earnings were withheld by a foreign government. (The official IRS website offers a basic description of the foreign tax credit.)

In most cases, you’re better off opting for the credit, which reduces your actual tax due. A $200 credit, for example, translates into a $200 tax savings. A deduction, while simpler to calculate, offers a reduced benefit. If you’re in the 25% tax bracket, a $200 deduction means you’re only shaving $50 off your tax bill ($200 x 0.25).

The amount of foreign tax you can claim as a credit is based on how much you'd be taxed on the same proceeds under U.S. tax law, multiplied by a percentage. To figure that out, you'll have to complete Form 1116 from the Internal Revenue Service.

If the tax you paid to the foreign government is higher than your U.S. tax liability, then the maximum foreign tax credit you can claim will be the U.S. tax due, which is the lesser amount. If the tax you paid to the foreign government is lower than your tax liability in the U.S., you can claim the entire amount as your foreign tax credit. Say you had $200 withheld by an outside government, but are subject to $300 of tax at home. You can use that entire $200 as a credit to trim your U.S. tax bill.

Example 1
Foreign Tax Paid$200
U.S Tax Liability$300
Foreign Tax Credit$200

Now imagine just the opposite. You paid $300 in foreign taxes but would only owe $200 to the IRS for those same earnings. When your taxes abroad are higher, you can only claim the U.S. tax amount as your credit. Here, that means $200. But you can carry the remaining $100 over one year—if you completed Form 1116 and filed an amended return—or forward up to 10 years.

Example 2
Foreign Tax Paid$300
U.S. Tax Liability$200
Foreign Tax Credit$200
Carryover Amount$100

The whole process is quite a bit easier, however, if you paid $300 or less in creditable foreign taxes ($600 if married and filing jointly). You can skip the Form 1116 and report the entire amount paid as a credit on your Form 1040. In order to qualify for this de minimus exemption, the foreign income earned on the taxes paid must be qualified passive income.

Who Is Eligible?

Any investor who must pay taxes to a foreign government on investment income realized from a foreign source may be eligible to recoup some or all of the tax paid via this credit. But they must have paid foreign income taxes, excess profit taxes or other similar taxes. More specifically, they include:

  • Taxes that resemble U.S. income tax
  • Any taxes that are paid by a domestic taxpayer as a substitute for income tax that would ordinarily be required by a foreign country
  • Foreign income tax that is measured in terms of production because of inability to determine basis or income within the country
  • Pension, unemployment or disability funds from a foreign country (some foreign social security-type income is excluded)

The credit is disallowed for nonresident aliens, unless they were residents of Puerto Rico for a full taxable year or were engaged in a U.S. business or line of work that paid them direct income. Citizens living in a U.S. territory other than Puerto Rico are likewise excluded. Finally, no credit is available for investment income realized from any source within a country that has been designated as harboring terrorist activities (IRS Publication 514 provides a list of these countries.)

Be Careful With Overseas Fund Companies

Given the difficulty of researching foreign securities and the desire for diversification, mutual funds are a common way to gain exposure to global markets. However, U.S. tax law treats American investment firms that offer international funds much differently than funds based offshore. It’s important to realize this distinction.

If a foreign-based mutual fund or partnership has at least one U.S. shareholder, it's designated as a Passive Foreign Investment Company, or PFIC. The classification includes foreign entities that make at least 75% of their revenue frompassive income or use 50% or more of their assets to produce passive income.

The tax laws involving PFICs are complex, even by IRS standards. But overall, such investments are at a significant disadvantage to U.S.-based funds. For example, current distributions from a PFIC are generally treated as ordinary income, which is taxed at a higher rate than long-term capital gains. Of course, there's a simple reason for this: to discourage Americans from parking their money outside the country.

In a lot of cases, American investors, including those living abroad, are better off sticking with investment firms based on U.S. soil.

How Do You Report Foreign Assets?

If you have foreign bank and financial accounts with an aggregate value exceeding $10,000, you must file FinCEN Form 114, Report of Foreign Bank and Financial Accounts, which can be filed electronically with the Financial Crimes Enforcement Network. If you meet specified thresholds for foreign financial assets, you may also have to file Form 8938, Statement of Specified Foreign Financial Assets, with your annual federal income tax return.

How Can I Avoid U.S. Tax on Foreign Income?

You can't exactly avoid it, but you can reduce the tax burden with the foreign tax credit. In short, you can show the U.S. how much money you paid in taxes to a foreign country and receive a credit. You can claim the foreign tax credit by filing Form 1116.

Who Can Claim the Foreign Tax Credit?

U.S. citizens and resident aliens who paid foreign income tax and are also subject to U.S. tax on that same income. Also, nonresident aliens can take the foreign credit if they are bona fide residents of Puerto Rico or pay foreign income taxes connected to a trade or business in the U.S.

The Bottom Line

For the most part, the foreign tax credit protects American investors from having to pay investment-related taxes twice. Just watch out for foreign-based mutual fund companies, for which the tax code can be much less forgiving. When in doubt about your situation, it’s a good idea to consult a qualified tax expert who can guide you through the process.

Understanding Taxation of Foreign Investments (2024)

FAQs

Understanding Taxation of Foreign Investments? ›

When Americans buy stocks or bonds from foreign-based companies, any investment income (interest, dividends) and capital gains are subject to U.S. income tax and taxes levied by the company's home country.

How are foreign investments taxed? ›

If you invest in foreign countries, you may be at a slight tax disadvantage, as other countries may tax the investments based in their region. Due to the income tax system in the United States, you would also have to pay U.S. income taxes on those investments. Fortunately, a tax credit may offer some relief.

How do I avoid double taxation on foreign capital gains? ›

If you qualify for the Foreign Tax Credit, the IRS will give you a tax credit equal to at least part of the taxes you paid to a foreign government. In many cases, they will credit you the entire amount you paid in foreign income taxes, removing any possibility of US double taxation.

How to report foreign investment on tax return? ›

File Form 8938.

If you meet specified thresholds for foreign financial assets, you must file Form 8938, Statement of Specified Foreign Financial Assets, with your annual federal income tax return (usually Form 1040). This form provides additional information on foreign financial assets and is filed with the IRS.

How much foreign interest is tax free in the USA? ›

For the tax year 2022 (the tax return filed in 2023), you may be eligible to exclude up to $112,000 of your foreign-earned income from your U.S. income taxes. For the tax year 2023 (the tax return filed in 2024), this amount increases to $120,000.

Do foreign investors have to pay capital gains tax? ›

If you are a nonresident alien, generally you will not have to pay U.S. capital gains tax on your investment earnings. If you are a resident alien, generally, you will be subject to the same capital gains tax as U.S. citizens.

Do I have to pay tax on money transferred from overseas to the US? ›

Recipients of foreign inheritances typically don't have a tax liability in the United States. And, if you're sending your own money from a foreign bank account to a domestic one, you won't have to pay taxes on the transfer.

Do you get taxed twice on foreign income? ›

The US is one of the few countries that taxes its citizens on their worldwide income, regardless of where they live or earn their income. This means that American expats are potentially subject to double taxation – once by the country where they earn their income, and again by the United States.

How can the U.S. avoid capital gains tax on foreign property? ›

If you sell your foreign property, you may be able to make a 1031 exchange (also called a like-kind exchange), in which you swap one investment property for another similar property on a tax-deferred basis. Many investors use this strategy to defer paying capital gains and depreciation recapture taxes.

What is the IRS threshold for reporting foreign assets? ›

If you are a specified domestic entity, you satisfy the reporting threshold only if the total value of your specified foreign financial assets is more than $50,000 on the last day of the tax year or more than $75,000 at any time during the tax year.

What is the IRS limit on foreign bank accounts? ›

A United States person that has a financial interest in or signature authority over foreign financial accounts must file an FBAR if the aggregate value of the foreign financial accounts exceeds $10,000 at any time during the calendar year.

Do I need to report foreign investment income? ›

Federal law requires U.S. citizens and resident aliens to report their worldwide income, including income from foreign trusts and foreign bank and other financial accounts.

What is the 330 day rule? ›

Generally, to meet the physical presence test, you must be physically present in a foreign country or countries for at least 330 full days during a 12-month period including some part of the year at issue. You can count days you spent abroad for any reason, so long as your tax home is in a foreign country.

How do I report foreign interest income on a U.S. tax return? ›

Forms 1099-INT or 1099-DIV - Foreign Dividends and/or Interest Received. To report foreign dividend or interest income, enter the information as though you had received a Form 1099-DIV Dividends and Distributions or Form 1099-INT Interest Income, but leave off the Payer's Federal Identification Number.

Do I have to pay tax on foreign interest income? ›

Unlike many foreign countries in which interest income is either tax-free or tax-exempt — the United States taxes foreign income, although the tax rate may be reduced if it meets certain requirements (Qualified Dividends or Long-Term Capital Gain).

How can a US citizen avoid double taxation? ›

The United States is a party to tax treaties designed to prevent double taxation of the same income by the United States and the treaty country. Certain treaties allow a U.S. citizen an additional credit for part of the tax imposed by the treaty partner on U.S. source income.

Can capital gains be taxed twice? ›

Double taxation occurs when a corporation pays taxes on its profits and then its shareholders pay personal taxes on dividends or capital gains received from the corporation. A financial advisor can answer questions about double taxation and help optimize your financial plan to lower your tax liability.

What type of business avoids double taxation? ›

On the special type of corporation of interest to small businesses is the Subchapter S corporation. This type of corporation avoids double taxation by having its income taxed to the shareholders as if the corporation were a partnership.

Are capital gains subject to double taxation? ›

The taxation of capital gains places a double tax on corporate income. Before shareholders face taxes, the business first faces the corporate income tax.

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