Credit or Deduction

• You have a choice as to whether you deduct any foreign taxes paid or accrued during the year as an itemized deduction on your Form 1040 Schedule A or as a credit using Form 1116. The choice needs to be made each year that you have foreign taxes and it can change from year to year. While you can choose whether to use a credit or a deduction year to year, you can't use some as a credit and some as a deduction in the same year. The IRS recommends filling out your taxes both ways to see which one provides you with the most benefit.
  
  

Qualified Foreign Taxes

• Not all foreign taxes qualify to be used as a credit. Generally, only foreign income taxes can be used as a credit on your U.S. taxes. All other taxes can be used as a deduction. While the general rule is that you can mix and match foreign tax credits and deductions in the same year, there is an exception. If the foreign taxes were incurred in a trade or business or in the production of income, the taxes can be deducted even if you took the tax credit for foreign income taxes.
  
  

Changing Your Choice

• You can change your choice as to whether to take a foreign tax deduction or credit even after you file your return. The IRS allows you to alter your choice at any time within 10 years of the original filing date of the affected return. You simply need to file an amended return, Form 1040X, to make the change. When making a change, you must also check to see if other returns are affected because of carry over amounts due to excess credits.
  
  

Credit Advantage

• All things being equal, using a tax credit is better than a tax deduction. Credits reduce your taxes owed, while deductions reduce your income. With the foreign tax credit, if the foreign tax rate is higher than the U.S. rate, it will cancel out your U.S. taxes owed on that income. If the foreign tax rate is lower, you will only have to pay the difference between the foreign rate and the U.S. rate. You can also use the credit even if you don't itemize your deductions. However, the foreign tax credit can only reduce your taxes on foreign income. It can't be used to reduce your taxes on U.S. income.