Foreign Tax Credit to offset capital gains tax and depreciation recapture

[smicp]

I own a house abroad and get rental income from it. I pay income taxes on the rental income in the foreign country. Because of how the FTC is calculated, I get a very small credit each year, and a large chunk of it is carried forward.

In a few years, if I decide to sell the house, I will have to pay a large amount due to the capital gains tax and depreciation recapture. Will I be able to offset this amount using the FTC carried forward?

[pk]

@smicp , generally speaking the carried  Foreign Tax Credit while  reducing your US  tax burden  may or may not extinguish  your total US tax burden -- this is  because :

(a)  form 1116  ( Foreign Tax Credit form ) ,limits  your allowable  tax credit to lesser of  the allocated  US tax to the   doubly taxed income  OR  the actual Foreign Taxes paid.  It is almost a never winning battle.

(b)  the gain  computed on the disposal/ alienation of foreign asset  is done per US tax laws and may be different  from the country where the property is located

(c)   Then there is the depreciation recapture -- ordinary  / marginal tax rate  for that part of the gain that is due / equal to the accumulated depreciation  and capital gain treatment for the rest of the gain.

I recognize that I am not  really adding anything to your statements in your post -- just making sure we are on the same page.

By the way , which country are you talking about ?

I am assuming that you are a US person  (  citizen / GreenCard / Resident for tax purposes ).

Is there more I can do for you ?

pk

[smicp]

Hi @pk,

Thanks a lot for your reply.

Please see my reactions to your points below:

(a) My rough calculation suggests that in the year the house is sold, the allocated US tax to the doubly taxed income would be significantly higher and would yield a significantly higher allowable tax credit. This is because the share of taxable income from foreign sources (after all the definitely related deductions and the pro-rata allocation of non-definitely related deductions) on total taxable income from all sources would be high, assuming that the capital gains (incl. depreciation recapture) from the sale of the house count as foreign income. Total tax due would also be high (because of the capital gains tax and depreciation recapture), so high share of taxable income from foreign sources combined with high tax due gives a relatively high maximum amount of credit allowed. This would allow me to use the FTC from the year of the sale of the house, as well as most of the FTC carried over from previous years. Does this seem reasonable?

(b) Yes, in my calculations above I am assuming the gain is computed as per US tax laws.

(c) Yes, in my calculations above I am dividing the gain into capital gain (taxed at 15% based on my assumptions) and depreciation recapture (taxed at the marginal taxation rate as ordinary income).

The country is Italy, where you pay income tax on rental income, but there is no capital gains tax or depreciation recapture when you sell a rental property.

Yes, I am a US person.

[pk · Accepted solution]

@smicp , generally agreeing with your statements I.e.

1.  Your total foreign source income would be your gross gain from the alienation of the property : i.e.  the  difference between  Sales Proceeds  (  Sales price LESS  allowable sales  expenses including any commission, transfer tax etc. ) and  Your adjusted basis (  Acquisition basis   + cost of any improvements  over the years LESS accumulated allowable  depreciation over the period as income property ).  This is the income being doubly taxed.

2. Your Foreign taxes paid on this income is  current taxes  paid PLUS your  Foreign Tax Credit carried forward ).

3.  Your total Foreign Tax credit allowable for current tax year ( the year of recognition of the disposal of the asset ) is the lesser of the actual taxes  paid / accrued  OR   allocated UIS taxes on this foreign sources income.

Hope this makes sense .

Please consider accepting and/or upvoting  this thread ( we are volunteers helping other users ) OR tell me what more I can do for you to earn your support.

pk

[smicp]

Thank you, @pk. This is very helpful.

[sorrytale]

I have a similar but somewhat different situation for which I am at a loss.  Canada, where we own a condo that has been rented out for several years, has a law that when you change use of a property from rental to personal it is a "deemed sale", where you must pay the capital gains and recapture of Capital Cost Allowances (Canadian style depreciation) as if you sold the property and repurchased it.  We are changing it to our second home this year so that applies to us.  Under the Canadian/US treaty we can ask the US to act as if we sold it and pay cap gain taxes this year, taking the foreign tax credit for the taxes of the deemed sale, but it is not in our interest to do so because of NYS taxes and some other issues.  

So we are paying a lot of cap gains to Canada this year and claiming no credit, as except for that treaty provisions the US does not recognize deemed sales.  However, we are also going to be paying a lot of Cap Cost recapture, and that gets lumped in on the regular Canadian return where we report rental income.  How do we figure out how much Foreign tax to report on our US return for credit?  We are only reporting the rental income as income received to the US, but the taxes we pay on that rental income will be in a higher bracket because of all the CCA recapture lumped in with it on the return.  

My thoughts would be to redo the Canadian return to calculate as if we just had rental income,  and use that number.  Or perhaps prorate the entire thing by the percentage of income that is rental?

Thanks for any advice

[pk]

@sorrytale , please give me day or two to digest what you have said in your post.  Will be back before the weekend is out.  Thank you for your patience  with my speed (  at my age of 84 , it is  normal, I think ).

pk

[pk]

@sorrytale , my initial reaction is  that this is a case of "mark-to-Market" scenario.

 Thus you comply with the Canadian requirement  of "deemed sale" / "Mark-to -Market" and settle the tax consequence thereof.  And then for the US purpose you do the same -- thus you have foreign source income ( computed under US laws, recovery of   depreciation under US laws,  Capital gains tax etc. all taken care of .  And thus you have foreign source income, foreign taxes eligible  for  FTC treatment.

This also means that your basis  in the property for future  disposal ( at least in the US case and logically for Canadian case ) is now FMV.

This is generally what happens ( in  US case ) for  US  persons ( GreenCard/ residents for tax purposes )  considered  long-term residents and when they  give up residency  and leave the country -- US collects the taxes on a mark-to market basis.

 So what gets in the way of this path --   1. you mentioned something about NYS taxes/situation; 2. anything in the tax code ?; 3. something else ?

As I see  this , both Canada and US federal  each get their share of the taxes ( had you actually sold  the asset ).  Unless of course there is loss in the "deemed" transaction.

Please tell me more  ( or PM me ) with more details as to why you would not want to do this.

pk

[sorrytale]

My understanding is that the US does not recognize deemed sales, but gives you the option to recognize them under terms of the tax treaty if you elect to do so:

"[w]here at any time an individual is treated for the purposes of taxation by a Contracting State as having alienated a property and is taxed in that State by reason thereof and the domestic law of the other Contracting State at such time defers (but does not forgive) taxation, that individual may elect in his annual return of income for the year of such alienation to be liable to tax in the other Contracting State in that year as if he had, immediately before that time, sold and repurchased such property for an amount equal to its fair market value at that time."

It is not in our interest to recognize the sale as we may never sell the property, it is not a principal residence in the eyes of the US but was one for about half the time in Canada (so the Canadian tax will be significantly lower), and we live in NYS where we will pay a heavy tax burden for the sale if we recognize it.  So our plan is to postpone any taxes in the US until one day when we actually sell the property and may be living somewhere cheaper.

But we still have to report the last round of rent we received,  Also fwiw, this is change of use deemed sale, without emigration.

thanks

[sorrytale]

And, what I should have said first, many thanks for your time and interest.

[pk]

@sorrytale , thank you for your response.  I understand the situation better and generally agree with the plan  of 

(a) recognize  the "use-change" mark-to-market"  for Canadian tax purposes.

(b) For US purposes, ignore the  " use change" issue, recognize any  rental income  during 2024, expenses, any residual/available  depreciation  ( during rental year/period ) -- foreign source income and claim  any possible /eligible foreign tax credit -- under US law and  mitigation of double taxation clause of the treaty

(c)  Assume that the property will get a US step-up when disposed off by the Estate ( in the distant future ).

Thank you for your kind words.

Is there more I can do for you ?

pk

[sorrytale]

Many thanks!

We will be doing as you suggest.  It is my understanding, but it would be nice to confirm, that if we follow this plan we should only take a foreign tax credit for the rental income.  Any taxes we pay on the "phantom" income of the cap gains and CCA recapture are not eligible for the foreign tax credit because they are not recognized by the US as taxes paid on actual foreign income (unless we take the aforementioned treaty provision to recognize the sale and adjust our US FMV, which we do not wish to do).  I guess that makes sense.  We would just be carrying that credit forward and are not likely use it across the next 10 years for which it is valid, it still would be good to confirm with you just in case.  

Thanks again for your help