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

[jtax]

I understand your points. But I still don't see how any of that refines "taxable income" from the  above cited code-wide meaning to be "foreign tax rule calculated taxable income" and why some of the deductions are US and some are foreign by your (and other folks on this forum). No one has cited any authority (code section, regulations or even non-binding guidance like instructions or publications) that makes me question that. 

The PAL carryover is not limited to 10 years. https://www.thetaxadviser.com/issues/2017/apr/disposing-passive-activities.html The FTC carryover is limited to 10 years and in many cases will never get used.  So for US taxes you won't lose the PAL unless you die owning the property and then you get a step-up in which case you can't complain about any of this (especially if you have no offsetting estate tax).

Technically I believe adjusting basis for depreciation is not "recapture." I think (but don't have time to verify) that recapture applies when upon sale depreciation allowed or allowable is taxed at ordinary income rates (such as when taking accelerated (i.e. not straightline) depreciation or certain types of business property).

[EDIT: This is not correct. Rather the it is taxed at your ordinary income rate capped at 25%. When you adjust basis on rental real estate (maybe with no accelerated deprecation), you are getting a subtle tax break. Your depreciation deduction reduced ordinary income, but you the basis adjustment upon sale taxes you at capital gains rates. That difference can be huge.]

I see what you are saying that when the depreciation comes back perhaps that should be accounted for in the FTC calculation. I think it is. You would have foreign capital gain in that year. When computing the FTC any foreign tax on that gain, as we've discussed, what what matters for the IRC 904 limit is US foreign source income/deductions. Your US foreign source income will be different than your foreign income by foreign tax rules. US income will be more because of the lower basis. That will increase the amount of the FTC because the numerator in the 904(b) calculation will be higher.

On a more general point Supreme Court Cases going way back have ruled that deductions are a "matter of legislative grace." That means you cannot reason that there should be a deduction (or credit). Rather you must find a statute that grants such a deduction. If it isn't there, then even if it should be there for fairness or some other reason, Congress has chosen not to give you that deduction. Congress can tax all of your income from any source and need not give any deductions. https://supreme.justia.com/cases/federal/us/305/281/#:~:text=Every%20deduction%20from%20gross%20inco....

I wonder if people are seeing what they think should be deductible on 1116 part I line 2 rather than finding authority for what should be deductible there.

But again I could be wrong. I'm not sure I'm right, I just still haven't seen anything that moves me the other way. 

[Stsxoz]

@jtax 

The PAL carryover is not limited to 10 years.

You are right. I already corrected this initial statement soon after posting. I was thinking of FTC carryover instead of PAL. This doesn't not change the validity of my original statement. I also made an additional post illustrating how the FTCs created by deprecation can expire without having a chance to ever claim them. I would be interested to hear your thoughts on this.

When you adjust basis on rental real estate (maybe with no accelerated deprecation), you are getting a subtle tax break. Your depreciation deduction reduced ordinary income, but you the basis adjustment upon sale taxes you at capital gains rates.

This is not correct. Having recently paid capital gains on an investment property, I know this from firsthand that the total depreciation over the years is taxed at ordinary income tax rate up to 25% and not at CG rate. Here is an external link explaining this clearly: https://inside1031.com/depreciation-recapture/

[Stsxoz]

As for your final point "I wonder if people are seeing what they think should be deductible on 1116 part I line 2 rather than finding authority for what should be deductible there."

The issue here is the authority you are referring to does not exist in certain aspects of 1116, line 2, as evident from different interpretations of the same section by different experts and even by your comments throughout this discussion. In the absence of this, naturally the conversation drifts toward "what should be" instead of "what is".

[jtax]

>This is not correct.

>Having recently paid capital gains on an investment property,

>I know this from firsthand that the total depreciation over the years is taxed

>at ordinary income tax rate up to 25% and not at CG rate.

I stand corrected. I have edited my post so as to not confuse future readers. Thank you.

[jtax]

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@Stsxoz wrote:

As for your final point "I wonder if people are seeing what they think should be deductible on 1116 part I line 2 rather than finding authority for what should be deductible there."

The issue here is the authority you are referring to does not exist in certain aspects of 1116, line 2, as evident from different interpretations of the same section by different experts and even by your comments throughout this discussion. In the absence of this, naturally the conversation drifts toward "what should be" instead of "what is".

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I see your point, but that's not the way the law works. If a term is defined by statute then that is what it means. If you are suggesting it means something else in a particular context (e.g. I.R.C. 904 is different than all other sections) it is on you to provide authority for why it means something else. Saying it should be something else is at best an argument and, it seems to me, a weak (at least not strong) non-binding argument.

I am totally unconvinced by the argument that line line 3 deductions are US deductions while the line 2 deductions are foreign deductions. That line 3 deductions are allocated among different types of income seems orthogonal to me.  Everything else in that section of form 1116 and indeed IRC 904 (which is actually authority) has nothing at all to do with foreign tax rule deductions. (That only comes to play in part II).

Here's another thing. What if under US law you get a definitely related deduction of $X. Under foreign tax law you get a  definitely-related deduction of $Y. Assume no overlap. Do you put $X+$Y or line 2? Or $X? Or $Y.

And why don't you put on line 3 any foreign deductions that aren't definitely related, such as a foreign standard deduction?

Fundamentally Part I of 1116 is about calculating the numerator of the I.R.C. 904(a) limitation. This is a US tax rule calculation. It has nothing to do with the amount of any foreign tax (which is where foreign tax rules would matter). It is an input to the limit function.

904 uses "taxable income" and talks about what US deductions are allowed (e.g. no personal exemptions). It has nothing to say about foreign income at all. It only talks about "taxable income from sources without the United States."

Foreign deductions only matter when the amount of foreign tax is determined and allowed by I.R.C. 901 (subject to the 904 limitation).

I remain unconvinced for whatever it is worth.

[Stsxoz]

Thank you @jtax

However, I found that your last response is mostly repeating what you have already said. As I mentioned in my yesterday's post, lets leave aside the question of the use of US code or international code for Line 2 for now (I follow your points on this, while acknowledging differing opinions of experts regarding which is right).

I was hoping to hear your thoughts on the specific item "depreciation" and, because of how it is not treated in the US like any other expense item, its effect on the FTC calculation based on the concerns I outlined in the example I shared (e.g. expiry of FTCs that were not allowed in earlier years (due to depreciation) before the event leading to depreciation recapture that would effectively allow FTCs but they are now long gone).

[jtax]

Fair enough on rehashing.

Re: depreciation and FTC. See my prior comment and this elaboration. When the depreciation is recaptured (upon sale of the foreign property) it seems to me that will usually give you higher US foreign source income. The  904 limitation numerator will be higher. It is lower now because of the depreciation deduction but higher then, and more foreign capital gains tax will be eligible for a possible FTC.  And maybe some carryfowards if they haven't expired (and the 904 limitation and any differential capital gains adjustments don't lower the 904 fraction).

Let's use an example. Just round numbers. Say $100k starting basis on the overseas rental property. $10k of rental income, $4k of depreciation. No other rental deductions in either country. Sell the property in a few years for $150k with accumulated depreciation of $16k. No rental income in final year (to simplify).

Current 904 limitation would be ($10k - $4k - share of general US deductions) / <worldwide US income>

Year of sale,

US gain is $150k - $100k - $16k = $34k (with $16k taxed at ordinary rates, max 25%). That is not foreign income. It is US income "from without the US" (foreign sourced income).

Foreign gain (using foreign rules) is $150k - $100k = $50k

Assuming there is a foreign capital gain tax, the 901 US income from foreign sources would be the US Gain figure which would be higher than the foreign rule calculation by the $16k accumulated deduction. This would result in a larger numerator in the 904 limitation calculation and would allow more the foreign tax in year of sale (and any carryforwards) to be used. However, because of low US capital gains rates, the US gain might need to be adjusted downward if any of the US tax on that gain were taxed below ordinary income rates.

Whether this increased FTC in the year of sale materializes or matters depends upon many things, including any LTGC rate adjustment, one's worldwide income at that time (the denominator in the limit), currency changes, etc. This might help but could hurt you.

At worst the tax on the $16k is deferred for a long time, which is a significant value. 

I'm not sure I followed your prior answer to the possibility  of not claiming the US depreciation deduction now. That would raise US tax, but it should also increase current FTC. If it is a wash (or in your favor), that could work. You would still have to recapture the "allowable" depreciation in the future, but you would have to do that anyway. [In the past I have researched the issue of whether you must take an allowable deduction. There appears to be no authority saying that you must take a deduction (unless the statute says so on only a couple do) and some saying that they are permissible rather than required. See https://digitalcommons.law.villanova.edu/wps/art58/ ]

I'm not sure that's helpful, but I tried.

[Stsxoz]

Thank you again @jtax 

Referring to your statement "Assuming there is a foreign capital gain tax, the 901 US income from foreign sources would be the US Gain figure which would be higher than the foreign rule calculation by the $16k accumulated deduction. This would result in a larger numerator in the 904 limitation calculation and would allow more the foreign tax in year of sale (and any carryforwards) to be used." we are on the same page on this. However, you response stops one step too short in addressing my question regarding the expiration of FTCs. Say the property was not sold within 10 years after FTC started accumulating but after 30 years. In that scenario all the credits from the 20-year period would have expired.

My point is the exclusion of depreciation from Line 2,1116 addresses this problem by allowing part of these FTCs apply in the year they become available (so that they don't have to expire without getting used). This balances out at the time of the sale of the property with the less FTC remaining available at that time to use against the US taxes including depreciation recapture.

Exclusion of depreciation from Schedule E would not be a good idea at all, as this would lead to a very high additional tax burden at the time of recapture even though one did not obtain any benefit from depreciation.

[jtax]

>Exclusion of depreciation from Schedule B would not be a good idea at all, as this would lead to a very high >additional tax burden at the time of recapture even though one did not obtain any benefit from depreciation.

Do you mean Schedule E? (Not Schedule B?)

But if the US tax on the rental is zeroed or reduced (because of a higher numerator in the 904 limit calculation) you did indeed get a benefit.  The question is how much? I.e. is your extra US tax offset by the higher FTC.

Even though there is more US income upon sale  you might also you to get a higher FTC then to offset any foreign-sourced capital gain. But it will be hard to predict.

[Stsxoz]

Yes @jtax I meant scheduled E. Edited and corrected my post now. Thanks