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Form 1116: Why Most Israelis Lose Thousands of Dollars in Foreign Tax Credits?
As an Israeli investor with US reporting obligations, are you taking advantage of all the credits you’re entitled to? Form 1116 is one of the most important tools for preventing double taxation, but many people miss it or fill it out incorrectly. The cost of this mistake can reach thousands of dollars per year.
For the 2025 tax year, to be filed in 2026, several important changes have been made to foreign tax credit rules. This article will explain in detail when and how to use Form 1116, what the most common mistakes are, and how to maximize the credit you’re entitled to.
What is Form 1116 and When Do You Need It?
Form 1116 (Foreign Tax Credit) allows US citizens to claim a credit for taxes paid to foreign countries. This is a crucial mechanism for preventing double taxation—a situation where the same income is taxed in both Israel and the US.
The requirement to file Form 1116 applies when the foreign taxes you paid exceed $300 for single filers or $600 for married filing jointly. If the foreign tax is below these amounts, you can choose a simple credit directly on Form 1040.
Types of Income Eligible for Foreign Tax Credit
Not all income taxed in Israel is eligible for credit on Form 1116. The IRS divides income into different categories, with each category requiring a separate Form 1116:
- General active income – wages, commissions, business profits
- Passive income – dividends, interest, rental income
- Income from certain foreign corporations – including CFC and PFIC
- Income from specific sources – such as oil and gas
This distinction is critical because the calculation rules and limitations differ between categories. A common mistake is mixing different types of income on one form.
Calculating the Credit: The Formula That Saves Thousands
The foreign tax credit is calculated using a complex formula that takes into account the ratio of foreign income to total income. The basic formula is:
Maximum Credit = (Foreign Income from Category / Total Worldwide Income) × US Tax on Total Income
The actual credit will be the lesser of: the foreign tax you paid or the maximum credit according to the formula. This is why proper planning of income and tax structure is important.
Special Cases: Investors in the Israeli Stock Exchange
Israeli investors holding shares on the Tel Aviv Stock Exchange face a complex situation. When an Israeli company distributes a dividend, Israel withholds 25% in tax (or 15% under the tax treaty).
For the US citizen, this dividend constitutes foreign passive income eligible for credit on Form 1116. It’s important to ensure you have all required documentation from the company or bank showing the tax withheld at source.
Practical example: If you received a dividend of $1,000 and $150 was withheld in tax in Israel, you can claim a credit of up to $150 (subject to formula limitations).
The Most Expensive Mistakes on Form 1116
From years of experience in this field, there are several recurring mistakes that cost taxpayers dearly:
Mistake #1: Not Filing a Separate Form for Each Category
Many people try to save time by mixing active and passive income on one form. This is not only technically incorrect, but can also result in significant loss of credits.
Mistake #2: Using the Wrong Exchange Rate
All amounts on Form 1116 must be in dollars. Using the wrong exchange rate (for example, year-end rate instead of average rate) can distort calculations.
Mistake #3: Failing to Document Foreign Taxes Paid
Without proper documentation of taxes paid in Israel, the IRS may reject the credit. Keep all documents, including tax withholding certificates and bank statements.
Foreign Tax Credit vs. Foreign Tax Deduction: Which is Better?
The question often arises whether it’s better to take a credit or deduction for foreign taxes paid. In most cases, the credit is preferable because it reduces US tax dollar for dollar.
The deduction, on the other hand, only reduces taxable income. For example: if you paid $1,000 in tax in Israel and you’re in the 22% tax bracket, the credit will save you $1,000 while the deduction will save only $220.
However, in some cases (such as when foreign tax is very high and the credit is limited), the deduction may be more beneficial. Like in the case of complex capital gains, it’s important to examine each case individually.
Carrying Over Unused Credits to Future and Prior Years
One of the major advantages of Form 1116 is the ability to carry over unused credits. If the foreign tax credit exceeds US tax in a given year, you can:
- Carry back the excess one year
- Carry forward the excess up to 10 years
This mechanism is especially crucial for investors with variable income or those dealing with high taxes in Israel in certain years. Proper planning can save thousands of dollars over time.
Special Cases: High-Tech Workers and Options
Israeli high-tech employees receiving options from US companies face a particularly complex situation. As detailed in our guide to employee stock options, taxation can be very complicated.
When exercising options, Israel may tax the difference between the exercise price and market price. This tax may be eligible for credit on Form 1116, but it’s important to ensure the tax was actually paid and properly documented.
New Changes for Tax Year 2025
As you prepare to file returns in 2026 for tax year 2025, several important changes have been made:
- Updates to tax rate tables for calculating maximum credit
- Changes to documentation requirements for foreign taxes
- Additional clarifications regarding taxation of digital income
It’s important to follow updates on the IRS website and ensure you’re using the most current version of the form.
Practical Tips for Completing the Form
Completing Form 1116 requires great precision and attention to detail. Here are several tips to help you:
Organize Information in Advance
Before you start, organize all required information: tax withholding certificates, bank statements, exchange rate calculations, and categorization of income.
Use Advanced Tax Software
Quality tax software can help with complex calculations and reduce errors. Make sure the software supports Form 1116 and all relevant categories.
Maintain Detailed Records
Keep all relevant documents for at least 7 years. In case of an audit, proper documentation can save you significant headaches and money.
When Should You Consult an Expert?
Although Form 1116 appears simple on the surface, the reality is much more complex. In the following cases, it’s highly recommended to consult a qualified tax professional:
- Income from multiple sources and different countries
- Complex investments such as PFIC or CFC
- High foreign taxes requiring special planning
- Cases of credit carryover between years
The cost of professional advice is often far less than the potential savings or the cost of errors.
Frequently Asked Questions About Form 1116
Do I Have to File Form 1116 for Every Foreign Tax?
No. If total foreign tax is below $300 (single) or $600 (married), you can take a simple credit directly on Form 1040 without filing Form 1116.
What If I Forgot to File Form 1116 in the Past?
You can file an amended return using Form 1040X. There is a time limit of 3 years from the original filing date or 2 years from the tax payment date, whichever is earlier.
Can I Claim a Credit for Tax Not Yet Paid?
No. The credit is only available for taxes actually paid or withheld at source. If the tax in Israel will be paid next year, the credit will only be available in that year.
How Do I Handle Taxes Paid in Shekels?
You must convert the amount to dollars using the average exchange rate for the year or the exchange rate on the payment date. The IRS publishes annual exchange rate tables for use.
Is Municipal Tax in Israel Eligible for Credit?
No. Only income taxes are eligible for credit on Form 1116. Property taxes, municipal taxes, or other non-income taxes are not eligible.
What’s the Difference Between Active and Passive Credit?
Active income (wages, business) and passive income (dividends, interest) are treated separately. Each category requires a separate Form 1116 and has different calculation rules.
Can I Combine Foreign Tax Credit with Foreign Earned Income Exclusion?
Yes, but not on the same income. If you choose exclusion on part of your income, you cannot claim foreign tax credit on that same portion. For more details, consult the IRS website.
Summary: Maximizing Your Foreign Tax Credit
Form 1116 is an essential tool for every American in Israel, but using it correctly requires a deep understanding of the rules and limitations. Common mistakes are costly, but proper planning can save thousands of dollars.
Remember: The deadline for filing your 2025 return is April 15, 2026. Don’t wait until the last minute—start organizing your information now. If needed, you can request an extension, but it’s better to be prepared in advance.
Investment in professional advice or self-education on this topic can pay for itself many times over. Don’t let double taxation eat away at your savings—take advantage of all the credits you’re entitled to.