Adjustment exception question about IRS form 1116, Foreign Tax credit

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spottedtiles
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Joined: Wed May 18, 2022 1:27 pm

Adjustment exception question about IRS form 1116, Foreign Tax credit

Post by spottedtiles »

Hi. I have a question regarding how capital losses effect whether or not you have to make the adjustment for line 1a on form 1116. Setup: The taxpayer is a schedule D filer and has income less than the cutoff $340,100 MFJ and the only foreign income is from passive activities. Say a person has $25K in total foreign source dividends and of that amount $21K is qualified foreign dividends which is over the $20K threshold for adjustment exception. BUT if a person has say $10K in realized foreign long term capital gains from selling an International ETF, BUT the person also has $20K in realized foreign short term capital losses from selling an international ETF resulting in a net capital loss of -$10K does this reduce the foreign qualified dividend amount from $21K to $11k when trying to figure out if you can use the adjustment exception of having less than $20,000? Does the capital loss have any effect on the $20K threshold or does only capital gains add to the qualified dividends to determine whether or not you are over the $20K level?

Here is the IRS 1116 instructions:

Per the IRS for Capital D filers from 1116 instructions: Schedule D Filers

Adjustment exception. If you qualify for the adjustment
exception, you can elect not to adjust your foreign source
qualified dividends. You make this election by not adjusting
these dividends or your foreign capital gains (or losses). If
you make this election, you must elect not to adjust any of
your foreign source qualified dividends.
You qualify for the adjustment exception if you meet both
of the following requirements.
1. Line 5 of the Qualified Dividends and Capital Gain Tax
Worksheet in the Form 1040 instructions or line 18 of the
Schedule D Tax Worksheet in the Schedule D (Form 1040)
instructions is less than or equal to:
a. $340,100 if married filing jointly or qualifying surviving
spouse,
b. $170,050 if married filing separately,
c. $170,050 if single, or
d. $170,050 if head of household.
2. The amount of your foreign source net capital gain,
plus the amount of your foreign source qualified dividends, is
less than $20,000.
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grabiner
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Re: Adjustment exception question about IRS form 1116, Foreign Tax credit

Post by grabiner »

Capital gains or losses from selling an ETF are not foreign income, because they are not taxed by a foreign country and the US considers sales of intangible property to be sourced to the US. (This is the same situation as with state taxes; if you sell stock in a DE corporation on the New York Stock Exchange, you don't pay tax to either DE or NY on the capital gain, only to your home state.)

In a similar situation in which the foreign capital gain was taxed by the foreign country (for example, from sale of investment property), I can't figure out from the IRS publications how the net loss counts for the adjustment; check with your tax advisor. (And use a human advisor; tax software has enough problems in less obscure parts of Form 1116 that I wouldn't trust it here.)
Wiki David Grabiner
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spottedtiles
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Re: Adjustment exception question about IRS form 1116, Foreign Tax credit

Post by spottedtiles »

grabiner: thank you for your reply. So to clarify, you are saying that selling an International stock ETF or mutual fund bought through Schwab or Vanguard (VTIAX total international fund for example) for a capital gain or a capital loss is NOT considered foreign income, but the dividends that VTIAX gives ARE considered foreign-sourced income? I am a little confused so if someone could please explain it some more.

So regarding the IRS 1116 form instructions: "2. The amount of your foreign source net capital gain,
plus the amount of your foreign source qualified dividends, is
less than $20,000" ......you are saying that selling VTIAX is not considered a foreign source net capital gain at all so therefore doesn't apply at all?

My ultimate question is this: for determining the adjustment exception, can a foreign source net capital gain which is a negative value because your international mutual fund capital losses exceed your international capital gains reduce the foreign source qualified dividends to get someone below the $20K threshold whereas they would have been above it based on foreign source qualified dividends alone?
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grabiner
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Re: Adjustment exception question about IRS form 1116, Foreign Tax credit

Post by grabiner »

spottedtiles wrote: Sun Jun 04, 2023 6:22 pm grabiner: thank you for your reply. So to clarify, you are saying that selling an International stock ETF or mutual fund bought through Schwab or Vanguard (VTIAX total international fund for example) for a capital gain or a capital loss is NOT considered foreign income, but the dividends that VTIAX gives ARE considered foreign-sourced income? I am a little confused so if someone could please explain it some more.
This is correct. The reason is that a mutual fund passes through dividends to its shareholders, and they retain their original character. If a mutual fund receives tax-exempt interest, or qualified dividends, or Section 199A dividends, the dividend paid to the shareholder is taxed the same as if the shareholder had received the dividend directly. Similarly, if a mutual fund holds a Japanese stock, the full dividend amount is taxable (and may be qualified or non-qualified), and the fund passes through the withholding of foreign tax to its shareholder.

In contrast, when you sell a share of a mutual fund at Vanguard or a share of an ETF on the stock exchange, the fund or ETF does not have any income to pass through; you realized the income yourself, and the transaction is considered to have happened at your home. It is not taxed by a foreign country unless you are a resident of that foreign country. (And if you are a resident of a foreign country which taxes your capital gains, that is foreign-source income even if the gains are on US stocks.)
So regarding the IRS 1116 form instructions: "2. The amount of your foreign source net capital gain,
plus the amount of your foreign source qualified dividends, is
less than $20,000" ......you are saying that selling VTIAX is not considered a foreign source net capital gain at all so therefore doesn't apply at all?
That is correct.
Wiki David Grabiner
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spottedtiles
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Joined: Wed May 18, 2022 1:27 pm

Re: Adjustment exception question about IRS form 1116, Foreign Tax credit

Post by spottedtiles »

Ok, for tax year 2022 Turbotax pre-populated or calculated a number for the qualified foreign source dividend and long term capital gains when filling out their questionnaire that was about $500 less than simply adding up the qualified foreign dividends from the 1099-DIVs (all the mutual funds were 100% foreign sourced income this year so no USA income "contamination" into the fund). For tax year 2021 the Turbotax pre-populated value and adding up the qualified foreign dividend MATCHED EXACTLY. Why did this change? I thought a possible reason was that in 2021 I did not have any international mutual fund capital losses whereas this year I did. Have other people noticed this? Is Turbotax wrong in this situation?
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