Form 1116 Foreign Tax Credit - High Tax Kickout for Foreign Rental Property

[jingle123]

I have a foreign rental property and I paid foreign tax from the rental income. However, the net rental income for US tax reporting is 0 after depreciation (the foreign country doesn't allow depreciation). 

When I report this foreign tax on form 1116, do I need to reclassify it to General category because of High Tax Kickout according to IRS code 1.904-4(c)

“If, after application of this paragraph (c), passive income is zero or less than zero, any taxes imposed on the passive income are considered related to the same separate category of income to which the passive income (if not reduced to zero or less than zero) would have been assigned had the income been treated as high-taxed income (general category, foreign branch category, section 951A category, or a specified separate category). For additional rules regarding losses related to passive income, see paragraph (c)(2) of this section.”

[pk]

@jingle123 , please could you tell me more  about your rental income:

(a) which country is the property situated in?  ( for purposes of co-ordination  with any tax treaty articles/conditions)

(b) your tax-home -- is it USA or are you abroad?

(c) Do you have other foreign income --- I ask because , absent  "general category" foreign source income, HTKO  may or may not be of advantage --- HTKO is based on effective tax rate imposed by a foreign taxing authority.

(d)  Are there other pertinent items/information to consider ?

I will circle back once I hear from you --yes ?

[jingle123]

(a) which country is the property situated in?  ( for purposes of co-ordination  with any tax treaty articles/conditions)

Australia

(b) your tax-home -- is it USA or are you abroad?

USA

(c) Do you have other foreign income --- I ask because , absent  "general category" foreign source income, HTKO  may or may not be of advantage --- HTKO is based on effective tax rate imposed by a foreign taxing authority.

I don't. But my understanding is that HTKO is not optional?

(d)  Are there other pertinent items/information to consider ?

No. The income difference is mostly from depreciation deduction rule. Australia does not allow depreciation deduction on rental properties (except for new constructions).

[pk]

@jingle123 , please accept my apologies for late response.

1. you are substantially correct in that the requirement to move the  foreign source income and the tax thereon  from "Passive" basket to "General" basket is  required ( i.e. it is mostly mandatory).

2. Note that the whole aim of  the  FTC regime is to mitigate the effects of double taxation  i.e.  we require  an equal amount of foreign source income that both jurisdictions tax under their own laws. 

3. In your particular case, for US tax purposes on form 1116 you recognize  the gross rental income ( foreign source income ) and reduce it by  allowable deductions ( per US laws including depreciation) resulting in zero or negative amount.  Thus your effective income on which to  compute the  "effective  tax rate " is meaning less.  So HTKO determination is not possible.

3. Another issue here is that  since there is NO  Foreign source income that is being doubly taxed -- so form 1116 usage becomes meaningless.

4.  The problem thus reduces to you having a foreign tax burden that does not meet the "doubly taxed" qualification for eligibility of FTC.

5.  You always have the option of not recognizing the depreciation and thereby have a positive  "net foreign income" that is then eligible for FTC.  But you still will have to recognize the basis erosion ( by allowable  depreciation whether recognized or not ) when you dispose off the  asset in the future.

That is my take on your situation.

Is there more I can do for you ?

[jingle123]

@pk , thanks for your response.

Where this tax sits does affect my tax liability. I have other passive income which I don't have enough credit to fully offset the US tax. But I don't have any General category foreign income. So if the rental tax paid sits in Passive, it lowers my tax liability. 

Re your (3) above:

"Thus your effective income on which to  compute the  "effective  tax rate " is meaning less.  So HTKO determination is not possible."

IRS code 1.904-4(c) states:

“If, after application of this paragraph (c), passive income is zero or less than zero, any taxes imposed on the passive income are considered related to the same separate category of income to which the passive income (if not reduced to zero or less than zero) would have been assigned had the income been treated as high-taxed income (general category, foreign branch category, section 951A category, or a specified separate category). For additional rules regarding losses related to passive income, see paragraph (c)(2) of this section.”

So the correct way to report it is to apply HTKO and reclassify the tax to the General category. It doesn't look like there is an option to treat it differently. Do you agree?

Thank you.

[pk]

@jingle123  it is an extremely convoluted sentence and all it confirms is that  if the  HTKO test succeeds then , even if the  net passive in come is zero or negative, the  taxes paid/accrued on that income is still HTKO/General category.  What I don't know is under what circumstances, would I have  net foreign source passive  income being zero/negative , triggering HTKO, recharacterizing income as general category and the  foreign tax thereon and still be able to use it absent other general category foreign source income ( large ) and taxed low by foreign authority.  There must be some case where this would work but I don't see it because I would still be limited by the  lesser of US tax on the  same doubly taxed income.

And I also have the general problem of while  you have to recognize the  income ( and pay taxes to the US ) , no where in the code does it say that  the taxpayer has to recognize the  taxes paid  ( granted it is mostly in his interest to do so ).   I have not found any case law on this  either.  And so I struggle.

Also I don't see how this affects PAL limitations either.

That is my take