Foreign tax credit on a foreign capital gain

[StephenF]

I had a $100K capital gain on the sale of a foreign rental property. As I am not considered a resident of that country, I paid around $32K in CGT to that country (Australia). I expected to get most of the US CGT ($15K - 15%) covered by a FTC, but the FTC only credits me around $8K. Add to that a $3K Net Investment Tax, I'm effectively paying over $10K in US tax on this CG.

In doing my US taxes, I reported the CG in "Sale of Business Property" section. This ends up in Schedule D. In the Foreign Tax section, I report the gain as passive income and the CGT paid to Australia as Foreign taxes on other income.  To the "Any foreign source qualified dividends or long term capital gains" question, I report the gain in "Foreign qualified dividends and l.t. capital gains". I do not the tick the "some of my foreign source capital gain are unrecaptured..". I do not enter any more information in the the pages that follow.

Looking at form 1116, my $100K CG gets multiplied by .4054 (which feels a little unfair given that this based on the 37% tax bracket whereas my highest tax bracket is only 24%). Therefore my gross foreign income is only "$40,500" which gets reduced to $37K by deductions. I have around $100K of wages income, so line 18 is $37K and line 18 is $140K, meaning line 19 ends up at .26. With a tax burden of $31K, I only end up with $8k credit.

Have I missed something or should I be doing something different?

I was really expecting more of tax credit here and wasn't expecting to pay over $10K in additional tax to the IRS.

Thanks,
Stephen

[DaveF1006]

The numbers you're seeing, especially the $40,540 figure, are the result of the Capital Gain Rate Differential Adjustment. This is likely the issue you are faced with.

The IRS uses the .4054 multiplier because you are paying a lower tax rate (15%) on that $100k than you are on your ordinary income (24%).

If the IRS let you report the full $100k on Form 1116, you’d end up using foreign taxes paid on income taxed at 15% in the US to offset taxes in your 24% bracket. To avoid this, the IRS reduces the amount of foreign income you can claim, so it matches the lower US tax rate.

You mentioned you did not tick the box for "Unrecaptured Section 1250 gain." This may be a potential red flag.

1. In the US, when you sell a rental property, the depreciation you took (or should have taken) over the years is "recaptured."
2. This portion of the gain is taxed at a maximum of 25%, not 15%.
3. If you had $20k of depreciation over the life of the property, $20k of your $100k gain should be taxed at 25%, and $80k at 15%.

The Net Investment Income Tax (NIIT) of 3.8% is a separate issue..

1. Standard Foreign Tax Credits (Form 1116) cannot be used to offset NIIT. 
2. While there is a complex workaround using the US-Australia Tax Treaty (Section 59(a)(2)), most standard tax software won't calculate this. You effectively have to claim a "Treaty-Based Return Position" (Form 8833). Without this, the $3,800 is a flat cost regardless of how much you paid in Australia.

Keep in mind, the $24k of taxes you didn't get to use ($32k paid minus $8k used) isn't gone. It carries back 1 year and forward 10 years to offset future foreign passive income. 

Please reach back if you have additional questions.

[StephenF]

Thankyou so much for your detail response.

I do understand the reason for the capital gain rate differential adjustment. I just feel that .4054 (which is based on 37% (15/37)) should really be .625 (15/24) to reflect the tax bracket I am in. Anyway, that is just a gripe, .4054 is the number we have to use and I know I can't change it.

I did simplify a few things in my original discussion. My actual gain was only $92,000, but I had $8,000 of depreciation which is where I got the $100K amount. I can see that turbo tax completed the "unrecaptured Section 1250 gain worksheet" and put this $8K amount in line 19 of Schedule D.

I went back to the Foreign Tax section and ticked the "some of my foreign source capital gain are unrecaptured" box and entered the $8k as the amount. This immediately increased the FTC to over $9K taking around $1,200 off my tax bill! Thanks!!

I did notice that the NIIT was not included the FTC calculations. I looked for information on using the treaty but didn't find anything concrete.

I already have some previous year foreign tax carryover, but now I'll have a lot more. I can't see situation where I'll ever be able to use it, but it's good to know it's there, at least for a few years.

I still feel I'm paying too much (but then again, who doesn't), but as long as I am not missing anything obvious, I guess I'll just have to pay it.

Thanks,
Stephen