After you have finished entering everything else in your return, try both options and see which gives you the best result.

Generally - but not always - taking the credit yields the best result.

1. When I select "Itemized Deduction" and enter the foreign taxes paid, I see my 'Federal tax due' goes down. Then I checked Schedule A form and its shows the foreign taxes paid under 'Other taxes', on form 1040 line 48 is empty. And on the 'Deductions & Credits' summary I see the foreign taxes amount show under 'Other Deductible Expenses'.
Not sure if this is right?
2. When I select "Taking a Credit" and fill Form 1116 , my 'Federal tax due' does not change and instead I get 'Excess Foreign Tax Credit'. I checked 1040 line 48 and its 0, but Form 1116 has the taxes under 'Passive Income' (since its a rental property in Canada)

The fact that option1 brings down my 'federal tax due' tempts me to submit using that option but wherever I read they suggest to select "Taking a credit".  Please help me understand whats better and right to do here.

Whichever option gives you the lower tax is the best option, and there is no "right" or "wrong," since you have two choices. It sounds like Option 1 is calculating as expected and since you have passive income Option 2 is not favorable to you.

Thanks for replying TurboTaxKitty. I understand option1 is giving me lower tax now. Can you please explain little more on option2 and why its not better from theory point of view. Option 2 leads me to 'Excess foreign tax credit' which means it will carryover to 2018, I got little confused here and why its carrying forward my credit vs the option1. Just trying to understand this for future.

Thanks for replying TurboTaxKitty. I understand option1 is giving me lower tax now. Can you please explain little more on option2 and why its not better from theory point of view. Option 2 leads me to 'Excess foreign tax credit' which means it will carryover to 2018, I got little confused here and why its carrying forward my credit vs the option1. Just trying to understand this for future.

Thanks for replying TurboTaxKitty. I understand option1 is giving me lower tax now. Can you please explain little more on option2 and why its not better from theory point of view. Option 2 leads me to 'Excess foreign tax credit' which means it will carryover to 2018, I got little confused here and why its carrying forward my credit vs the option1. Just trying to understand this for future.