I own a foreign rental property. I pay income tax in the foreign country on my rental income, with limited deductions (especially because depreciation cannot be deducted in this country).
For US tax purposes, I need to report my foreign rental income and I can claim deductions for a range of expenses (mortgage interest, repairs, management fees, ...) AND depreciation with a 30-year depreciation schedule. As a result of this, my net taxable income on Schedule E is basically 0 and I do not owe income taxes related to my foreign rental property to the US. I can still claim a foreign tax credit on Form 1116 for the income tax I pay in the foreign country, but this credit will not be used, so it will carry forward for up to 10 years.
Assume that I sell my foreign rental property in 5 years. There are no capital gain or depreciation recapture taxes in the foreign country, so I don't owe anything. However, in the US I owe: (i) a capital gain tax on the profit I make above the original cost basis of the house (forget about the adjustments for now), and (ii) income tax at my marginal tax rate on the depreciation deductions allowable (and claimed) over the 5 years that need to be recaptured.
My questions are:
1) Is my overall understanding above correct, or am I missing something?
2) Can I use the foreign tax credits carried forward to offset the depreciation recapture tax (or the capital gain tax)?
3) If the answer to (2) is no, I feel like the overall result is not "fair": I already pay income taxes to the foreign country, so being "forced" to claim the depreciation deduction to reduce my taxable rental income in the US does not help me, as it nullifies the benefits of the foreign tax credit, which cannot be used to offset the depreciation recapture tax when I sell the property. Is there a way to avoid this? I guess an option could involve not claiming depreciation and then using Form 3115 to claim it back when the property is sold (to offset the recapture), but not sure if this makes sense.
Thank you in advance for your help.
1) Is my overall understanding above correct, or am I missing something?
Yes.
2) Can I use the foreign tax credits carried forward to offset the depreciation recapture tax (or the capital gain tax)?
Yes, in the tax year you sell the property, assuming you do so in the 10 year window.
3) Moot point, and really no need to answer #3.
Hi Carl, thank you for your reply.
Just to clarify, can the foreign tax credits carried forward be used to offset just the depreciation recapture tax, or also the capital gain tax if needed? I assume the answer is both because they are all taxes on passive income (same category as the FTC), but I would like to double check.