Form 1116 - Line 18

toad · Post by **toad** » Sun Jul 08, 2012 1:54 pm

Hi,

Interesting thing happened: I have been working through tax scenarios for sale of a Canadian rental property. After reading the instruction for form 1116, and using info from the Qualified Dividend/Capital Gain worksheet, it appears that I can pay less tax then if I didn't sell the property . ie. if I owe $5000 in tax (on regular W2 income), it can be reduced to $0 because the foreign tax credit I can claim for the house sale is larger than the tax incurred at a 15% capital gain rate.

Does this sound possible, or am I/Turbotax making a mistake?

Thanks

toad · Post by **toad** » Thu Jul 12, 2012 9:43 pm

Any ideas on this?

JGCA · Post by **JGCA** » Thu Jul 12, 2012 11:27 pm

You are not allocating the income and teh tax by catagory , employment income is not going to be reduced by tax paid on investment income from Canada. There is a proper allocation required by income, tax paid and then you take this ratio. Many posts have been written on this read them to understand teh mechanics of the allocation method you need to follow.

toad · Post by **toad** » Fri Jul 13, 2012 12:27 am

JGCA,

Thanks for your response. I do understand the allocations to different categories and the rules you are mentioning. I filed my return correctly last year with two 1116s for general and passive income.

I am using Canadian tax on capital gains as a credit against USA tax on capital gains. However...

The "problem" is Line 20 (on form 1116) indicates the total tax paid on both capital gains and normal income. It is multiplied by the ratio of foreign source income (capital gains in this case)/Line 18, to determine the maximum size of the credit.

Line 18 is not total income (1040 line 41), instead it is adjusted downwards because of capital gains, (Worksheet says to multiply 15% amount by 0.5714 and then subtract from total income) which actually makes the ratio saturate at 1.

So it allows me to max out the credit up to the total amount of tax I paid for the year on both capital gains and income. This doesn't seem right, but I am following the instructions...

nelsona · Post by **nelsona** » Fri Jul 13, 2012 7:38 am

Wages are "general limitation" income, while property sales are 'passive". You will have at least 2 1116's, and they cannot be used against each other.

nelsona · Post by **nelsona** » Fri Jul 13, 2012 7:39 am

Are you using software, because there are THREE limits on the credit, and your credit will be limited to the smallest of these.

toad · Post by **toad** » Fri Jul 13, 2012 6:03 pm

I am using software. There are no wages as foreign income.... my only foreign income is the capital gains/passive income.

Here is an example that may help:

Scenario A: I make 100k in the USA, and 300k in Canada. Both as regular income. I paid 50k tax in Canada Suppose the tax rate was a flat 15%. Then the max credit I can claim is 300k/400k = 0.75 x $60k (15% of 400k) = $45k, and since 45k <50k>> 1 * 45k = 45k. Since 45k <50k, I can claim 45k.

As shown in Scenario B, it is possible to claim your full amount of tax on all income.

Does that make more sense?

toad · Post by **toad** » Fri Jul 13, 2012 6:09 pm

I don't know what happened to my Scenario B in the above post.... here it is:

Scenario B: I make 100k in the USA - general income, and 300k in Canada - passive income/capital gains. The credit is then 300k/(400k - (300k*.5714)) = 300k/229k = 1.31 >> 1. Therefor you can still claim the full 45k

nelsona · Post by **nelsona** » Fri Jul 13, 2012 9:13 pm

Of course if your tax rate in Canada is less than your EFFECTIVE rate in US, you will get all Cdn tax back: that is why treaties try to limit foreign tax.

The problem comes when your Cdn tax rate is HIGHER than your US effective rate.

The other thing to remember is that the $300K you add to your US income probably cost you more than $45K in US taxes. Just take off the $300K from your income and see.

toad · Post by **toad** » Mon Jul 16, 2012 12:23 am

Thanks for the response nelsona.

The 15% tax rate was just an example. So you are saying with a foreign tax credit for capital gains it is possible to get a credit for more than the US tax obligation on that income?

nelsona · Post by **nelsona** » Mon Jul 16, 2012 9:47 am

No.

You will get the smaller of (a) the US obligation, or (b) the Cdn tax paid.

That is ALWAYS how it works.

nelsona · Post by **nelsona** » Mon Jul 16, 2012 9:50 am

And the US obligation is the Effective amount, not the marginal amount, whicch limits your credit even further.

Bottom line: foreign tax credit si not a winning proposition.

toad · Post by **toad** » Wed Jul 18, 2012 1:44 am

Update: I found my mistake. Not only does Line 18 have to be modified for capital gains, but also Line 1a (on Form 1116). As expected, when I fixed this, only a partial credit is applied and I get to enjoy a large amount of double-taxation.

Interesting observation: The higher the amount of foreign capital gains, the higher amount of relative credit can be claimed. ie. The average tax rate goes down. However at some point AMT kicks in and makes you pay.