American citizens must report all types of income on their U.S. tax returns regardless of the country in which it's earned or received. There are some narrow exceptions to this general rule, but if one doesn't fit your situation, you have to report the entire lottery prize and will most likely pay tax on it. If you're a resident of a foreign country, the foreign earned income exclusion won't help reduce your tax bill either.
Taxable Lottery Prizes
There is more to your taxable income than just earnings from employment, business and investment. Any gambling winnings, which include foreign lottery prizes, are reportable on your tax return as well. Reporting your lottery prize doesn't necessarily mean you have to pay tax on it, but if you do, it's subject to the same graduated tax rates that apply to your other income. Whether you'll have additional taxes to pay has nothing to do with the country in which you won the lottery; rather it depends on how much the lottery winnings are and the other types of income you report.
FEIE Excludes Lottery
Americans who live and work abroad and satisfy a number of requirements are eligible to take the foreign earned income exclusion, which essentially allows them to exclude a certain amount of income that's earned abroad from their taxable income. For purposes of the FEIE, only the foreign income you receive for performing services through employment or self-employment is considered “earned” and therefore potentially excludable. Foreign lottery winnings, however, are never treated as earned income. As a result, even if you consistently take the FEIE and don't pay tax on your employment and self-employment income, you still need to report the lottery winnings on your U.S. tax return.
Reporting Lottery Prizes
The full amount of your lottery prize is reported on the “other income” line of your tax return – you won't find a specific line to report gambling or lottery winnings. If you itemize your deductions and have gambling losses, you do have the option of deducting them on Schedule A to reduce your taxable income, and ultimately, the amount of tax you'll owe on the foreign lottery prize. However, if you choose to take the standard deduction instead of itemizing, you don't get to deduct those losses.
Foreign Tax Credits
The tax rules of each nation can vary, but in the event you have to pay taxes on the lottery winnings in a foreign country, the IRS does allow you to take a foreign tax credit so that you don't pay tax on the same income in more than one country. When preparing your return, you'll calculate the U.S. tax you owe on all of your income, including the foreign lottery winnings. Generally, the foreign tax credit will directly reduce the U.S. tax you owe by the amount of foreign tax you paid. The foreign tax credit rules are lengthy and may be more complex depending on your tax situation.
Michael Marz has worked in the financial sector since 2002, specializing in wealth and estate planning. After spending six years working for a large investment bank and an accounting firm, Marz is now self-employed as a consultant, focusing on complex estate and gift tax compliance and planning.