Form 1116 to claim Foreign Tax Credit for income tax paid on rental income

[smicp]

I am using TurboTax online to claim a foreign tax credit for income tax that I paid abroad on my foreign rental income, and I have some doubts on how the software allocates the standard deduction under Part 1, line 3.

Assume that my adjusted gross income is 100k, of which 95k from a W-2 and 5k of "net" rental income from Schedule E (i.e., after deducting expenses and depreciation). Assume also that the total rental income (including expenses and depreciation of 20k) is 25k.

On Form 1116, in Part 1, line 3, TurboTax allocates the standard deduction of 27,700 based on a gross foreign income of 25k (line 3d) out of a gross income for all sources of 120k (95k+25k) (line 3e), which corresponds to a 20.8% share. This gives a result for line 3g of 5,770. This effectively more than offsets the net rental income of 5k, leaving me with a negative value on line 7, i.e., with no foreign tax credit that can be claimed.

This sounds a little unfair, as the net rental income is only 5% of the adjusted gross income (5k out of 100k), yet it is assigned 20.8% of the standard deduction. Because adding this net rental income to my adjusted gross income increases my U.S. tax liability, I feel like I should be able to claim a credit for this additional liability. Am I doing something wrong or is this just how it works?

[AmyC]

Unfortunately, the instructions for Form 1116 show the gross amount as the portion used for calculations. Do you have the gross income showing on line 1? Losses on line 5? Make sure that you really have the form completed correctly. Perhaps there is a treaty option, see Tax Treaties.

[Dane7]

I have the same issue with my foreign rental, after days of researching this, it really seems that it is calculated correctly, unfortunately thy allocate the percentage of the standard deduction related to the foreign income based of gross foreign income, so many times if you have just small foreign profit it will not allow you to apply the tax credit that year, but postpones it to the next year. 

[jtax]

Very good question.

I think you should be deducting the Schedule E expenses on line 2 of form 1116. That would address your valid concern. Those Schedule E expenses are "definitely related" to the foreign gross income.

Even if you get beyond this be aware that the Part III credit calculation limits the foreign credit to  

your total US tax liability * (your foreign income / your worldwide income)

for those with small foreign income, that ratio is small. because US taxes are often so much lower than foreign taxes, you are not likely to "get back" the foreign tax. Rather what is happening is that you will not be paying to the US what the US would have taxed you (usually less than the foreign government).

re: line 2 see the 1116 instructions and its further references as you wish, page 17

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

which says:

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.
Also include on line 2 state and local income taxes related to
foreign source income. For more information, see Pub. 514
and section 861 and the regulations under that section.
Attach a statement listing the separate expenses included on
line 2.

Don't include any interest expense on line 2. See lines 4a
and 4b for special rules for interest expense.

[smicp]

Hi @jtax, thank you very much for your reply.

I am actually deducting the Schedule E expenses on line 2 of form 1116, and I agree that this is correct. So basically when I mentioned a net rental income of 5k, I was referring the fact that line 1a minus line 2 of form 1116 is already 5k.

However, on top of these expenses, as you know form 1116 requires that I deduct the pro rata share of other deductions not definitely related (line 3), which in my case is only the standard deduction. And that's where the problem arises: the pro rata share is calculated using the gross foreign income (25k instead of 5k), so the foreign income gets allocated a large share of the standard deduction. While I have the impression that this is technically correct, I find it a bit unfair in practice.

[Dane7]

Same here, it feels unfair, I had a foreign rental profit of 6 thousand dollars, I paid taxes on that profit in Europe, and now I am required to pay taxes on that profit even here in US, I wasn’t expecting that. Due to the calculation involving the standard deduction which won’t allow me to use any of my foreign tax credit that I earned this year. And yes, it is supposedly calculated corectly like that. Very few people seems to understand this correctly. The way that this is explained is that you are not being double taxed since the portion of the standard deduction which is allocated for your foreign income offsets foreign taxes paid. The standard deduction is being allocated based on your gross income, so if you have a small net foreign profit, but large gross foreign profit before your deductions, the large portion of the standard deduction allocated to the foreign income will eliminate your net profit, and won’t allow the credit to be used this year, but it will be forwarded to next year. You pretty much use up portion of your US standard deductions against the foreign profit.

[DaveF1006]

It depends. I am not sure how you are interpreting the standard deduction in this case. The US standard deduction has nothing to do with calculating the Foreign Tax Credit. Every bit of income rather foreign or domestic is reported in gross income amounts that have nothing to do with the standard deduction.

I think what you are referring to are deductions you report in completing your foreign tax credit section. If you report deductions here, all this does is decrease your foreign tax credit. Unless you specifically have these, you would leave this section blank. These deductions, when reported, are only used in the calculation of the foreign tax credit and are not reported anywhere else in your return.

Let us know if this helps.

@Dane7 

[Dane7]

Yes I agree with you that the standard deduction has nothing to do with calculating the amount of  foreign tax credit, but it  affects if you can use the foreign tax credit in that year. It won’t allow you to use the credit, because the number on line 7, part  1, On form 1116 ends up being negative number.