Foreign tax credit (Form 1116) and California state income tax.

[Anonymous]

I recently moved from Canada to the US and am currently a resident of California; as a result, I have to pay Canadian taxes for part of my 2022 income due to multi-year compensation.

Trying to file Form 1116 with the IRS but found the instructions around "Non-exempt state income taxes" to be very confusing, specifically, the IRS Publication #514 states the following:

- You must allocate and apportion your interest expense and state income taxes under the special rules...

- If state income tax is imposed in part on foreign source income, the part of your state tax imposed on the foreign source income is definitely related and allocable to foreign source income.... If the total income taxed by the state is greater than the amount of U.S. source income for federal tax purposes, then the state tax is allocable to both U.S. source and foreign source income.

The document then went on to give an example:

- Your total income for federal tax purposes, before deducting state tax, is $100,000. Of this amount, $25,000 is foreign source income and $75,000 is U.S. source income. Your total income for state tax purposes is $90,000, on which you pay state income tax of $6,000. The state does not specifically exempt foreign source income from tax. The total state income of $90,000 is greater than the U.S. source income for federal tax purposes. Therefore, the $6,000 is definitely related and allocable to both U.S. and foreign source income. 

Assuming that $15,000 ($90,000 − $75,000) is the foreign source income taxed by the state, $1,000 of state income tax is apportioned to foreign source income.

Since California taxes foreign income, I figured this rule applies to my case; but it's unclear where the amount of the state income tax apportioned to foreign sourced income should go on Form 1116; my best guess is it should be added to Line 1a to be part of the foreign-source gross income, but it's counterintuitive.

Does anyone know how this case should be handled?

[ThomasM125]

Line 1(a) of Form 1116 is where you report your foreign income. You qualify to treat the California tax on your foreign income as foreign tax paid, but the foreign income is the income from Canada, so that goes on line 1(a). The California tax paid on your Canadain income, along with your tax paid to Canada on that income, is reported in Part II of Form 1116. 

[Jim Aitken]

I live in California and recently sold a farm (rental) property in Canada.  Looking ahead to my 2023 tax filings, I know that I will have to pay Canadian capital gains tax, and I know that I will be able to claim a foreign tax credit for this  (form 1116) on my Federal return.  But I have no idea on how California will want to treat this.  Here are the options that I see so far:

!.  Claim the CDN tax as a Credit on my federal return and assume it is not allowed on my CA return.  Results in low Federal tax but very high CA tax.

2. Claim the CDN tax as an Expense on my federal return, and assume it will be allowed on my CA return.  Result is much higher federal tax and lower state tax.

3. Claim the CDN tax as a Credit on my federal return and claim it as an Expense on my CA return.  This results in the lowest tax in both cases, but requires that I manually add the expense to my CA return as a "selling expense".  Not sure that I'm allowed to do this.

4.  In searching this forum I found this item (below) from ThomasM125 which seems to offer a fourth approach of paying the full CA tax, but then adding it to Form 1116 as an additional foreign tax paid.  This sounds strange and I would like to further verify if its allowed.

I would really appreciate some advice on this.  It has been my experience that local tax preparers are woefully lacking when it comes to foreign tax issues.

Jim A.

 ThomasM125

Expert Alumni

Line 1(a) of Form 1116 is where you report your foreign income. You qualify to treat the California tax on your foreign income as foreign tax paid, but the foreign income is the income from Canada, so that goes on line 1(a). The California tax paid on your Canadain income, along with your tax paid to Canada on that income, is reported in Part II of Form 1116. 

[sabasu]

I have a similar situation for tax year 2024, but for India.

I am an US citizen and resident of California. I sold a piece of land in India in July 2024. The Indian tax authorities deducted a hefty tax at source (a.k.a TDS, Tax Deducted at Source), from my sale proceeds @~24%. This is kinda a witholding tax to be adjusted against my Indian Tax Return (a.k.a ITR) . India's fiscal year runs from April 1 to Mar 31, so I will file my ITR on or after April 1, 2025 and expect to get a refund out of my TDS.

In a post (https://ttlc.intuit.com/community/taxes/discussion/re-reporting-capital-gains-on-sale-of-land-in-ind...), I have been advised..."You will have to prepare your federal return, then your California return to determine that tax paid.  Then you will return to the federal portion to include that additional tax." and was pointed to this thread. 

I lived the whole year in California as an US citizen, but I sold a property in India and made some Capital Gains income. Therefore, I have both US income from salary, dividends, interest, investments etc. PLUS India Capital Gains, on which I have paid Indian taxes. I understand that I can claim credit on my India taxes, but I can't understand how to separate out the California taxes for my Indian Capital Gains, since my California income will include both US income and Indian income. 

@ThomasM125 says 

• "Line 1(a) of Form 1116 is where you report your foreign income." Ok, so I report the Indian Capital Gains in Line 1(a) of Form 1116
• "The California tax paid on your Canadain income..." How do I get that because my State tax will include BOTH US income and Indian Income (capital gain). How do I know how much is my California tax ONLY on my Indian income, which I will reported in Part II of Form 1116.

@Jim Aitken, @ThomasM125 can you pls help?

Thanks in advance.

[RobertB4444]

When filling out your California tax return the easiest way to get the amount paid for taxes on the Indian amounts is to do the complete return and then go back through and delete the Indian amount from form 1116.  Note the difference in the taxes and then re-enter the Indian amount.  That difference in taxes due is what is deductible on your Indian return.

@sabasu 

[SomeoneStrugglingWithFilingTaxes]

FTC Limitation:
Am I right in saying that trying to claim the state tax on foreign income, as foreign tax paid, may not help if one has already hit the limit on Federal Foreign Tax Credit (FTC) with original credit from the actual foreign tax paid ?

[DaveF1006]

No, that isn't necessarily true. Generally, state taxes on foreign income are not considered foreign taxes paid for the purposes of the Federal Foreign Tax Credit (FTC). The FTC is designed to offset U.S. federal taxes on foreign income, but it only applies to taxes paid to a foreign country—not state taxes within the U.S.

However, some states may offer deductions or credits for foreign taxes paid, but this would be separate from the federal FTC. Each state has its own tax rules, so it’s worth checking whether your state provides any relief for foreign income taxation.

@SomeoneStrugglingWithFilingTaxes 

[SomeoneStrugglingWithFilingTaxes]

So, it is moot point anyway ...
BTW, I am in California, so no credit.

[SomeoneStrugglingWithFilingTaxes]

Here is what ChatGPT says, it i is in line with your option number "3":

How can I enter the gross sale proceeds of foreign land sales as different amounts in federal and California filing? In federal the foreign tax paid is not deducted from gross, but that can be claimed as FTC. For California the gross has to be reduced by the foreign tax paid. How can we manage to show the amounts for the same sale differently for federal and California filing ?

ChatGPT said:

To handle this correctly, you need to report the same foreign land sale with different gross proceeds and tax treatments for federal and California because of their differing tax rules:

Summary of the Issue:

• Federal: Report full gross proceeds. Foreign tax paid is not subtracted from the gross sale; instead, you claim it as a Foreign Tax Credit (FTC) or deduction.

• California: Does not allow the FTC, so the foreign tax paid must reduce the gross proceeds (treated like a selling expense).

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How to Do This in Tax Software (like TurboTax, Lacerte, ProSeries, or similar):

You’ll need to use a state-only adjustment method. Here’s how:

1. Enter the full gross proceeds for the federal return:

• Enter sale on Form 8949 and Schedule D using the full gross proceeds.

• Then claim the foreign tax paid as a credit or deduction (typically on Form 1116).

2. Adjust the California return to reflect reduced proceeds:

Because California doesn’t allow the FTC or deduction for foreign tax paid, you’ll need to reduce the gain manually:

Option A: Adjustment on CA Schedule D or 540

• Use Schedule CA (540) – this form reconciles federal and CA income.

• On Part II, line 8z ("Other income adjustments"), enter a negative adjustment to reduce capital gains for the foreign tax paid.

Example entry:

"Adjustment for foreign tax paid on land sale – CA doesn’t allow FTC"

Option B: Enter a different amount in the CA column of the 8949 or D

• Some professional tax software lets you enter a CA-only column for 8949/D differences.

• If so, reduce the proceeds by the foreign tax paid for the California version only.

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Additional Tip:

Keep good documentation explaining why the gross proceeds differ between federal and state. If the difference is questioned, you can point to California’s disallowance of the FTC and the guidance in FTB Pub. 1001.