How to correctly adjust qualified dividends and long term capital gains on line 1a of form 1116 when there is capital gains excess?

[big toes]

When there is more than $20,000 of foreign (including resourced) qualified dividends and long term capital gains (not over the 15% tax rate), I assume that typically in the most simplified scenario (with no US or foreign losses), the foreign source has to be adjusted in line 1a by removing the pro rated amount that was taxed at 0% (worldwide amount found on line 9 of Qualified Dividends and Capital Gain Tax Worksheet [QDCGTW]), and removing 62.12% of the pro rated amount that was taxed at 15% ( worldwide amount found on line 17 of QDCGTW). In line 18, the same reduction is applied to worldwide Q-div and L-cap-gain.

For line 1a, the pro rated amount is typically calculated by a fraction, with the numerator being the foreign source of Q-div and L-cap-gain for a category and column of 1116, and the denominator the worldwide source of Q-div and L-cap-gain.  The denominator is typically found on line 4 of QDCGTW, which is simply the sum of worldwide Q-div and L-cap-gain.

However, when the foreign earned income exclusion completely eliminates all earned income, and when there is very little ordinary income such as interest, the result is a large capital gains excess, which is simply the remaining standard deduction applied to Q-div and L-cap-gain, after first being applied to ordinary income. For the purpose of the Foreign Earned Income Exclusion Tax Worksheet (FEIETW), a second QDCGTW is filled out with line 4 reduced by the capital gain excess.

The problem is that I have seen examples and some tax software, when calculating the pro rata amount of Q-div and L-cap-gain at the 0% and 15% tax rates to be removed from line 1a of 1116, they use the the newly reduced line 4 as the denominator, instead of the worldwide Q-div and L-cap-gain before the reduction by capital gains excess.  What this effectively does is to double count the standard deduction on the foreign source Q-div and L-cap-gain, because line 3g of 1116 is already doing this. The result is very little foreign tax credit and still a large amount of double taxation, and some test inputs result in negative numbers for line 7 when 3g is greater than 1a (due to double reducing the standard deduction) which may break the form.

For the denominator of the pro rata fraction, is it correct to use the newly reduced line 4 in the QDCGTW, or before reduction by the capital gain excess?

[Mike9241]

have you seen the 1116 instructions starting on page 7?

there is nothing in the instructions about changing anything on the QDCGTW

basically, the way the 1116 will work is to not allow a higher FTC than the US tax paid on the same income. 

https://www.irs.gov/pub/irs-pdf/i1116.pdf 

[big toes]

Simplified below

[big toes]

Sorry, I was going in a roundabout way of thinking. I thought about it again and found a simpler way to describe the problem. Please let me reword it.

For the adjustment to foreign long term capital gain on line 1a of 1116, the full portion taxed at 0% and 59.46% of the portion taxed at 15% rates are to be removed. How would you pro rate these amounts between foreign and U.S. long term capital gain,  if worldwide long term capital gain is greater than the taxable income?

The numerator of the pro rata fraction would be the total foreign long term capital gain.

For the denominator, would you use the worldwide long term capital gain, or the taxable income?

Example:

• $30,000 total worldwide long term capital gain, of which $20,000 is foreign sourced
• $12,000 standard deduction
• $18,000 taxable income
• $30,000 foreign earned income exclusion reduces the $40,000 threshold for 0% rate to $10,000
• $10,000 worldwide L-cap-gain taxed at 0% rate
• $8,000 worldwide L-cap-gain taxed at 15% rate

For line 1a of 1116, the foreign L-cap-gain to be entered must be reduced by:

• the amount that was taxed at 0% rate
• and 59.46% of the amount that was taxed at 15%

How would you pro rate these amounts to foreign L-cap-gain?

• Option 1:    $20,000 foreign L-cap-gain / $30,000 worldwide L-cap-gain (result = 67% ratio, line 19 of 1116 would be greater than "1" and all foreign tax is available to reduce US tax to zero)
• Option 2:    $20,000 foreign L-cap-gain / $18,000 taxable income (result = $937 in line 1a,  $4000 in line 3g, negative number in line 7, no foreign tax credit, full US tax of $1,200) This is what I've seen some software do

I don't know if the software was purposefully using the taxable income as the denominator, or if this was because it was taking the number from line 4 of the QDCGTW, which was reduced by the capital gain excess as instructed by the FEIETW, but the reduction is supposed to be only for the purpose of calculating tax on FEIETW. Reducing line 4 of QDCGTW by capital gain excess essentially results in the same number as the taxable income.  But the taxable income already has the standard deduction subtracted from it, and line 3g and 7 of 1116 are again subtracting the pro rated amount of standard deduction. So essentially, Option 2 is double subtracting the standard deduction from line 1a and greatly reducing the available foreign tax credit.