When filling out Form 1116 for foreign rental income, how do i enter the income?

[eia123]

I want to claim a foreign tax credit for taxes I paid on foreign rental income. How do I enter this on form 1116 in Turbotax? 

Lets assume $10,000 foreign rental income. I had $6,000 allowable expenses, so according to schedule E I have $4,000 foreign income. 
How do I enter this on form 1116? Do I enter 4,000 as foreign income in this category? 
The letter of TurboTax seems to suggest that I enter $10,000 income, and then at the deductions it tells me that I shouldn't enter any deductions (the $6,000 expenses) because i take a standard deduction. That seems incorrect? 

Online sources seem to contradict whether to enter $10,000 as income and then report the $6,000 as definitely related expenses, or to enter $4,000 as income (after all, this is then added up as 'total income' on form 1040).

[jtax]

For business (including rental) you should deduct those schedule E expenses on the 1116 as expenses directly related. Enter $10k foreign income and $6k in 1116 deductions directly related to the $10k income. 

What's happening is that that section of the 1116 is figuring out your net foreign income. You get to subtract the expenses directly related to the income (schedule E in your case but could be schedule E or perhaps investment fees or something else in other cases) and a proportional share of the standard deduction. The standard deduction is not directly related to any income so the 1116 is allocating it some to the rental income and some to the rest of your income.

[jtax]

Also see e.g. page 17 of the 1116 instructions for part I, line 2:

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

Line 2
Enter your deductions that definitely relate to the gross
income from foreign sources shown on line 1a. For example,
if you are reporting foreign business income on line 1a,
include on line 2 business expenses such as supplies and
advertising incurred as part of operating the foreign business

Unless you find more specific instructions for rental real estate, I think it is the same as a business for 1116 purposes.

The instructions of form are clear that Line 1 is the gross income. So you need to enter line 2 expenses to get to your net foreign income. (And then later TT will also take of a share of the standard deduction.)

Remember the 1116 is not giving you back the foreign taxes. Rather it is giving you back (at best) the US tax on the income the foreign country is taxing. Since US tax rates are so low, you almost always wind up paying more to the foreign country. But at least you don't pay twice. (Usually, but this is a very complex area.)

[Stsxoz]

Should depreciation calculated in Schedule E be included in the rental expenses reported on Form 1116, Line 2? These depreciation costs were certainly not part of the actual expenses or part of the rental expenses reported in overseas tax return.

[jtax]

This stuff makes my head hurt. 

You could try it both ways and see if it makes a difference in your FTC. If not don't worry about it.

But what is actually the right thing? 

Simplifying a lot (there are many edge cases that might or might not apply to you) what the 1116 is computing the amount of the FTC allowed. To do that starts with the foreign income (separately in each category). 

Then it reduces that income by deductions. That includes deductions related to that income and a share of general deductions (e.g. the standard deduction). That produces the "net foreign income" (again of that category).

That is used to compute the ratio of that net foreign income to your worldwide taxable (not gross) income (line 18).

This ratio is then applied to your US Tax to reveal the max FTC allowed. (Line 21) You get a FTC of the min(actual foreign tax paid, max FTC).

The idea is that you are finding out how much the US taxed you on that share of income. The max FTC will be what the US taxed you on. If the foreign tax is more, too bad. The idea is not give you a credit for all foreign tax. Rather it is not make you pay twice what the US would charge. Usually you wind up paying more because most the US has such low tax rates.

All that being said, I would think that you should include US depreciation as a definitely-related expense because the US reduces that from your tax on that activity.  However, if you did not claim the depreciation expense on Schedule E (nothing requires you to take a deduction you are entitled to -- show me authority that says otherwise if you know of any), then I wouldn't include it on the 1116 line 2. 

But here's what I think what that would do (mock it up all ways and see/verify for yourself). 

1. It would increase your US tax on the rental. But it would also increase your ratio of net foreign income (now without the US depreciation deduction) to worldwide income and result in a higher FTC.  That might be a wash. (Calculate it both ways and let us know).

2. When you sell the property you must adjust the basis for depreciation "allowed or allowable" so that would result in higher capital gains and/or recapture. It would not matter if you had not deducted the depreciation, you still have to adjust as if you had. That might or might not matter in your situation down the road (e.g. if you are in a low, even zero capital gains bracket at the time of sale, if you don't have a gain even after the adjustment, or if you die owning the property and get a step-up in basis to FMV).

See I.R.C. 1245(2)(A)( "'recomputed basis' means, with respect to any property, its adjusted basis recomputed by adding thereto all adjustments reflected in such adjusted basis on account of deductions (whether in respect of the same or other property) allowed or allowable to the taxpayer or to any other person for depreciation or amortization.") https://www.law.cornell.edu/uscode/text/26/1245 (emphasis added).

https://ttlc.intuit.com/community/tax-credits-deductions/discussion/sale-of-rental-property-deprecia...

[Stsxoz]

Thank you @jtax!

This section of the return makes my head hurt as well! 

As you would suspect, excluding depreciation from line 2 leads to a higher credit, as its inclusion increases line 6 to exceed line 1a. Depreciation was included in Schedule B for the reason (i.e. allowed, allowable distinction) you also highlighted. I found another discussion on this topic since posting this here: https://ttlc.intuit.com/community/investments-and-rental-properties/discussion/gross-income-on-forei...

In that thread, referring to depreciation, the Turbotax expert stated "In viewing the form 1116, there is no separate entry for depreciation. In fact if you look at Part 1 line 2, all of the expenses definitely related to income are the expenses that the foreign country used to reduce the income for determining the foreign taxes you owe. If it wasn't included as an an expense, then it can't be claimed."

Based on this I intend to exclude the depreciation on the 1116 line 2 unless you strongly suggest otherwise.

[Stsxoz]

Further to my above post, I found the following explanation by @pk that supports the idea of including only the expenses allowed under the laws of the foreign country on the line 2, 1116:

"...one point one needs to remember is that  Foreign Net Rental income  ( IRS sometime calls it Gross Rental income ) is  Total Rental income LESS deductions allowed under the laws of that country ( which may or may not be the same  as US version ).  The logic behind this is that your net foreign rental income is based on local laws --that is what you received as foreign income."  

https://ttlc.intuit.com/community/tax-credits-deductions/discussion/form-1116-line-3e-from-rental-in...

[jtax]

Thank you for the links. @pk is usually right about these kind of things. But, for whatever it is worth, I'm not sure here. I understand the point. I just cannot find any authority for that position. Authority here is the tax code, regulations, or cases. Instructions or other guidance can be helpful but are not the law. Please feel free to point me at some. Or consult with a professional (CPA, enrolled agent, or tax attorney) who deals with the FTC all the time (not a couple times a year.)

I'm not sure because the point is to NOT compute the foreign income as as shown on a foreign return. That's not how I think it works. Rather the income in question is US income that comes from a foreign source.  That is based on US rules not foreign rules. The source rules are described in I.R.C. 862. (compare to 861). https://www.law.cornell.edu/uscode/text/26/862

Three Points:

1. The law does not say foreign income. It deals with US income from foreign sources

The computation of the limit in I.R.C. 904(a) is your US tax times "taxable income from sources [outside the US]" divided by your "entire taxable income" ... https://www.law.cornell.edu/uscode/text/26/904

This does not say "foreign income." It says "taxable income" from foreign sources (per I.R.C. 862). "Taxable income" is defined in I.R.C. 62 to be "gross income minus the deductions allowed by this chapter." This chapter means the US tax code, not the foreign tax code. https://www.law.cornell.edu/uscode/text/26/63

Gross income is "all income from whatever source derived." I.R.C. 61(a). https://www.law.cornell.edu/uscode/text/26/61

If someone can point me at the code section or regulation dealing with the FTC that says "foreign income" or "foreign deductions" or redefines "taxable income" for sections 901 et. seq. I would reconsider.

2. Form 1116 does subtracts other deductions that are US only deductions

If that were wrong why does Form 1116 Part I line 3 require that you deduct the US standard/itemized deduction? It the deductions were about the foreign tax code this would be the foreign standard/itemized (or other) deductions.

3. Foreign deductions are taken into account when allocating foreign income among classes of income

Instead of subtracting foreign deductions from US taxed foreign-sourced income, foreign deductions are taken care of when allocating for taxes among different categories of foreign income. This does not matter to you if your only foreign income is in one category, as is probably the case for you. It would apply if you had, say, foreign salary income and also foreign sourced rental or other passive income.

See page 21 of Pub 514. https://www.irs.gov/pub/irs-pdf/p514.pdf

[Stsxoz]

Thank you very much for your detailed response @jtax.

From the seeming contradiction in the responses I am receiving from two very well versed TurboTax experts, it is clear that this part of the 1116 instructions is vague and not fully understood or uniformly applied. As for background, the CPA who helped me with our return last year, who works for a major tax firm that specializes in expat returns, excluded the depreciation from Line 2. As I am doing our return myself this year, and being someone who values fully understanding things before doing anything, I wanted to also seek input from experts here before adopting this position once again in this year's return.

In relation to the three points you presented here are my thoughts.

I see where you are coming from in your Point 1, but to me this still does not provide any conclusive evidence one way or another (as to whether the US based deductions or source based deductions should be included on Line 2, 1116).

As for your Point 2, I can see that the reasoning behind the inclusion of this deduction is very different (i.e., to fairly allocate the deduction that applies to the entire taxable income reported in the US return between the foreign and the US sources) than the expenses reported on Line 2.

The section of Pub 514 you are referring to in your 3rd point is the only section where I was able to find such specific example on the application of "deductions" in any of the relevant IRS publications. As you also mentioned, this specifically quotes "...also have deductions of $4,400 that, under foreign law, are not definitely related to either the wages or interest income." To me, this is conclusive and the definition of "deduction" should not be isolated only to the allocation of foreign taxes just because the term was defined in that section.

Based on the above, I am leaning toward the @pk's interpretation for the expenses to be included on Line 2. Many thanks again for your thoughts on this!

[jtax]

@Stsxoz 

Thank you for detailed response and for providing some background.

If you had professional advice from a CPA with significant ex-pat experience (especially with foreign rental or business income -- not just people living overseas), then I think doing it the same way the CPA did it is reasonable. Might or might not be right, but it would seem to be a good-faith attempt to get it right (as opposed to making stuff up). [Of course if wrong and the IRS were to challenge you would of course, always owe the tax and interest, but not penalties because of reasonable reliance on professional advice.]

Back to the substance. 

 I see where you are coming from in your Point 1, but to me this still does not provide any conclusive evidence one way or another

Yes, that is the issue. But you have to figure out who has the "burden of proof" here. I think that what I referenced is the definition of the words used in I.R.C. 904(a)/1116. It is up to you (or the proponents of the "foreign deduction" theory) to show why the same words used in 904 have a different meaning than they do everywhere else in the tax code. And indeed why they mean something different on 1116 part i line 2 and line 3. 

>As for your Point 2, I can see that the reasoning behind the inclusion of this deduction

>is very different (i.e., to fairly allocate the deduction that applies to the

>entire taxable income reported in the US return between the foreign and the US sources)

>than the expenses reported on Line 2.

Yes that is true. But it makes no sense to me (absent ANY authority) why the country of the deductions would be different? The difference between 2 and 3 is whether the deduction only applies to the income category or must be prorated. Not whether it is a US or foreign deduction. If it were different why would you deduct a share of the US standard deduction to get a net foreign income? That would be irrelevant. It would be the foreign standard deduction (or equiv). 

My point is that it seems to me (absent authority I haven't seen) that  I.R.C. 904/1116 is not computing foreign net income per foreign tax rules. It is computing US income from foreign sources using US tax rules.

Then it calculates the ratio of that to worldwide US-taxed income times the the actual foreign tax paid on the US foreign source income. Figuring the foreign tax actually paid (or accrued) is the only place the foreign tax rules (deductions, etc.) comes into play.

The section of Pub 514 you are referring to in your 3rd point is the only section where I was able to find such specific example on the application of "deductions" in any of the relevant IRS publications. As you also mentioned, this specifically quotes "...also have deductions of $4,400 that, under foreign law, are not definitely related to either the wages or interest income." To me, this is conclusive and the definition of "deduction" should not be isolated only to the allocation of foreign taxes just because the term was defined in that section.

Sorry but I don't buy that. That discussion is talking about allocating the foreign TAX (among categories of foreign income. To do that you must follow the same procedure that I.R.C. 904/1116 does for allocating US deductions to US income from foreign SOURCES. The algorithm is the same but it is applied to different inputs to obtain a different output.

Sorry to be a pain here, but I just don't see it the same way. I could certainly be wrong, but I have seen no authority that budges me.

[Stsxoz]

@jtax 

Thank you very much for your detailed response. I appreciate your attention to this.

To be frank, I follow some of your points and am somewhat divided on how to go ahead with this now. 

There is one more thing that I would like to share to illustrate a case that I think this form has an issue in handling (unless I am using it incorrectly). Let us consider the following case:

Foreign-sourced rental income: $35,000

Expenses on the above income: $45,000

Foreign interest income: $10,000

Let us assume that no rental losses were allowed in the US return due to Passive Activity Loss limitations, and hence no US tax savings from the rental loss. On the other hand, US tax applied to the foreign interest income of $10k. So, from what I understand what Form 1116 does is that, under the assumption that rental and interest income are both categorized as "passive", it will simply calculate zero FTC for the above scenario, as a result of allowing for "unallowed" rental losses, as if they generated any US tax savings. This creates an unfair treatment of the interest income by not allowing any credit for the taxes paid (to both countries) on that income.

Please let me know if the above makes sense, and if it does if you see any errors in my application of this process. If the followed process is correct, considering the main purpose of the form, probably a more accurate way is to only include the rental expenses to the point they reduced the US taxes in the current return and not beyond that (i.e. up to the rental income in the above scenario). 

I look forward to hearing your thoughts on this. Thank you!

[jtax]

@Stsxoz 

But the PAL is merely suspended. You get to take that when you have other passive gains or when you sell the property. That is just a timing issue.

There are sections about losses in the 1116 instructions and pub 514. They are astonishingly complex. I suspect because there are many ways to game the system (especially using losses in one category to offset another).

Remember the FTC is not designed to let you recoup foreign taxes. That is a common misconception.

Rather it is to allow you to recoup US tax on US foreign source income. If the US doesn't tax that foreign source income, you don't get an FTC even though you have paid foreign tax. This can easily happen, for example, with long-term capital gains which the US can tax at zero. But other ways as well. (For example more US deductions than foreign deductions allowed for the income.)

[jtax]

I do want to emphasis that I am discussing this in general terms. I am not giving you advice as to what you should do in your situation. I do not know that answer. I am just explaining the way I am thinking about this. I may be totally off base or just wrong. That I am unconvinced by arguments otherwise does not mean I am correct in general or in your particular case.

[Stsxoz]

Thank you again @jtax 

By no means I am under the impression that the FTC is designed to let one recoup foreign taxes, and this is not what the example I presented was showing. The example is showing that the US taxes that are being paid on the foreign interest income are not being recouped as a result of the "unallowed" foreign rental property losses showing as an expense in Form 1116. Is this making sense?

As for your comment "But the PAL is merely suspended. You get to take that when you have other passive gains or when you sell the property. That is just a timing issue." This is not a given, one might never sell the property or not have other passive gains.

There is also the depreciation recapture, which effectively treats this by lowering the property's basis by depreciation. Therefore, one could argue that any reduced US tax liability due to depreciation will be paid back at the time of the sale. Given that the lowered basis already takes depreciation into account, I am not sure how it makes sense to also include it as an expense on Line 2, 1116.

[Stsxoz]

@jtax.

I have further reflected on my final point, and I maintain the position that depreciation only helps postpone the tax until the property is sold. Similar to your point on PAL that it is merely suspended, I guess my point with depreciation is that it will be recaptured in due time and hence it only postpones the payment of the US tax liability and not eliminate it (unlike all the other expenses). One can probably argue that at the time of the recapture, foreign tax credits that were carried forward can be utilized, but the presence of the 10 year carry forward rule would not  allow this for properties held longer, and these FTCs could never be claimed. In that scenario it would not be reasonable to consider depreciation a "definitely related" expense for 1116, even if one agrees to the point you were making about the source of these expenses (and that they should be based on the US treatment and not foreign).