What Is the Foreign Tax Credit?
How It Works for Americans Living in Italy
For Americans living abroad — especially in high-tax countries like Italy — understanding how the Foreign Tax Credit (FTC) works is essential to avoid double taxation and comply with both U.S. and Italian tax laws.
Here’s a straightforward guide to how the Foreign Tax Credit works, and how it can benefit U.S. citizens living in Italy.
🇺🇸 What Is the Foreign Tax Credit?
The Foreign Tax Credit is a provision in the U.S. tax code (IRC §901) that allows U.S. taxpayers to reduce their U.S. tax liability by the amount of foreign income taxes paid or accrued to a foreign government — in this case, Italy.
It’s claimed on IRS Form 1116 and is one of the primary tools used to avoid being taxed twice on the same income.
How It Works
Let’s say you’re a U.S. citizen residing in Italy, and you earn employment or self-employment income there. You pay Italian income taxes (IRPEF) to the Agenzia delle Entrate.
When filing your U.S. tax return, the U.S. will still tax your worldwide income, but:
- You can claim a credit for the Italian taxes paid on that income.
- This credit reduces your U.S. tax dollar-for-dollar, up to the amount of U.S. tax attributable to that foreign income.
Example
- You earn €50,000 in Italy and pay €14,140 in IRPEF (Italian Income Tax).
- The U.S. taxes that income at, say, $2,856.
- You can claim up to $15,271 (2025) as a foreign tax credit, wiping out your U.S. liability, and creating a carry forward balance!
- Most expat preparers focus on a fast simple return, we aim to take maximum use of these FTC, because it’s YOUR money, and it’s not a small amount!
If you paid more tax in Italy than in the U.S., the excess may be carried back one year or forward for 10 years.
Common Scenarios for Americans in Italy
1. Employees in Italy
- If you’re working under an Italian contract and paying through payroll (busta paga), your income is likely already taxed in Italy.
- You report it on your U.S. tax return (Form 1040) and claim the FTC using Form 1116.
2. Self-Employed / Freelancers
- You pay taxes to Italy (INPS + IRPEF).
- You may also be subject to U.S. self-employment tax (Social Security/Medicare), which cannot be offset with the FTC.
- However, you can still use the FTC for income taxes (IRPEF).
3. Retirees or Passive Income
- Income such as Italian pensions, rental income, or dividends is taxable in both Italy and the U.S.
- FTC can be used to avoid double taxation — but be careful with dividends and capital gains, where tax treaties may affect outcomes.
Foreign Earned Income Exclusion vs. Foreign Tax Credit
Some Americans abroad use the Foreign Earned Income Exclusion (FEIE) — which excludes up to $120,000+ of income from U.S. tax — instead of the FTC.
But in high-tax countries like Italy, the Foreign Tax Credit is usually the better option because:
- Italy’s tax rates are higher than U.S. tax rates, so FTC gives full relief
- Using FEIE can limit future tax benefits (like the foreign housing deduction or child tax credit)
- You can’t use both on the same income
How to Claim the Foreign Tax Credit
- File Form 1040 with the IRS
- Attach Form 1116 for each type of income (e.g., general, passive)
- Report foreign income and taxes paid (converted to USD)
- Maintain records of tax payments to Italy (CUD, CU, Modello Redditi, etc.)
If your foreign taxes are less than $300 ($600 if married filing jointly), you may not need to file Form 1116 and can claim the FTC directly on Form 1040.
Other Considerations
- Social Security taxes (INPS) are not eligible for the FTC — but the U.S.-Italy totalization agreement helps avoid double contributions.
- You must choose either the FTC or the exclusion — not both on the same income.
- You must file timely and accurately — missing the FTC window can cost you.
✅ Summary: Why It Matters for Americans in Italy
| Benefit | Explanation |
|---|---|
| Avoids Double Taxation | Offset U.S. taxes with Italian IRPEF |
| Flexible Use | Carry excess credits forward or back |
| Works Well in Italy | Italian taxes are usually higher |
| Required for Compliance | Still must file U.S. taxes annually |
Most Accountants Don’t Think Strategically About the Foreign Tax Credit
While many accountants know how to fill out Form 1116, few take the time to strategically plan around the Foreign Tax Credit. In reality, the FTC isn’t just a compliance form — it’s a powerful planning tool. Smart timing of income, foreign tax payments, and even the use of carryforwards can significantly reduce U.S. tax liability over multiple years. Unfortunately, many U.S. tax preparers who work with expats simply input data without considering how to maximize credits across future years, avoid passive basket traps, or optimize carryforwards. If your accountant isn’t asking about your Italian tax calendar, payment timings, or long-term residency goals, they may be leaving money on the table.
Using the Foreign Tax Credit to Offset Roth Conversion Tax
One lesser-known strategy is using the Foreign Tax Credit to offset U.S. tax on a Roth conversion. If you’re an American living in Italy with high Italian tax payments, you may have unused foreign tax credits carried forward from prior years. These can be applied to reduce or eliminate the U.S. tax liability triggered by converting a 401K or IRA into a Roth IRA. Since Roth conversions are fully taxable in the U.S. (Italy doesn’t like Roths, so this must be done carefully!), this creates a unique opportunity: convert retirement savings at little to no additional U.S. tax cost by strategically using available FTC carryforwards. This is a powerful tool for long-term financial planning — especially for expats looking to lock in tax-free Roth growth.
Need Help?
If you’re a U.S. citizen living in Italy and want to optimize your tax situation — or avoid costly mistakes — it’s wise to work with a professional who understands both systems. That’s us!
Need a referral to a bilingual tax professional or want help filing Form 1116 correctly? Get in touch — we can help you get started.
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