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FEDTAX * IRS * HOME * PUB_514

Capital Gains and Losses

If you have any capital gains or losses, you may have to make certain adjustments when figuring your foreign source taxable income and your foreign tax credit.

If you file a Schedule D (Form 1040), Capital Gains and Losses, and both lines 16 and 17 of that schedule are gains, you must adjust the amount you enter on line 17 of Form 1116. You must also make this adjustment if you received capital gain distributions and you figured your tax using the Capital Gain Tax Worksheet (found in the Form 1040 instructions). Complete the Worksheet for Line 17, found in the Form 1116 instructions, to figure this amount.

If you have any foreign source capital gain or loss, you must adjust the amount of capital gain or capital loss you enter online 1 or 5 of Form 1116. This adjustment is discussed next.

Adjustment for Foreign Source Capital Gains and Losses

You must adjust your foreign source capital gains to reflect U.S. capital gains tax rates. You do this by completing Worksheet A in the instructions for Form 1116. Also, your foreign source capital gain net income included in the amount on line 1 of Form 1116 cannot exceed your worldwide capital gain net income.

You must adjust your foreign source net capital loss (to the extent taken into account in determining worldwide capital gain net income) based on the U.S. tax rate applicable to the worldwide capital gain the loss offsets. You can use Worksheet B in the Form 1116 instructions to make this required adjustment.

A "foreign Schedule D" is used to make these adjustments to your foreign source capital gains and losses.

However, a "foreign Capital Gain Tax Worksheet" is used to make adjustments to your foreign source capital gain distributions if you figured your tax using the Capital Gain Tax Worksheet, instead of Schedule D.

You must complete the "foreign Schedule D" or the "foreign Capital Gain Tax Worksheet" before completing Worksheet A or B.

Foreign Schedule D. If you had a foreign source capital gain (and line 17 of the Schedule D you file with your U.S. tax return shows zero or a positive number) or a foreign source capital loss, you must complete a separate Schedule D using only your foreign source capital gains and losses. On this "foreign Schedule D," complete Parts I, II, and III.

If Part lll, line 17, is a gain, complete Part lV (through line 36) of that Schedule D. However, if line 15 or line 19 of your foreign Schedule D is more than zero, complete a "foreign Schedule D Tax Worksheet" and skip lines 20-36 of the foreign Schedule D. Also complete the Worksheet for Line 17 and Worksheet A (Capital Gains) in the instructions for Form 1116.

If Part lll, line 17, is a loss, you can use Worksheet B (Capital Losses) in the instructions for Form 1116 to make the adjustment.

Use your foreign Schedule D only to compute the adjusted amounts. Do not file it with your return.

Foreign Capital Gain Tax Worksheet. If you figured your tax using the Capital Gain Tax Worksheet and some or all of your capital gain distributions were foreign source, you must complete a separate Capital Gain Tax Worksheet using only foreign capital gain distributions. See the Instructions for Form 1116 for special instructions for completing this foreign Capital Gain Tax Worksheet and Worksheet A.

Use your foreign Capital Gain Tax Worksheet only to compute the adjusted amounts. Do not file it with your return.

More than one category. If you have foreign source capital gains or losses from more than one separate limit income category, complete a separate foreign Schedule D for each category. Then, depending on whether the category has a gain or a loss on line 17, use whichever of the following procedures applies.

Loss categories. For each category for which line 17 of the foreign Schedule D shows a loss, you must adjust the amount of your foreign loss (to the extent taken into account in determining your worldwide capital gain net income) based on the tax rate applicable to the worldwide gain the loss offsets. You can use Worksheet B (Capital Losses) in the Form 1116 instructions to make this required adjustment. To do so, add together the net losses (from line 17 of your foreign Schedules D) of all the separate limitation categories that have losses on line 17 of the foreign Schedule D. Enter the total of all the net losses, to the extent taken into account in determining your worldwide capital gain net income, on line 1 of Worksheet B. Complete Worksheet B. Use only one Worksheet B for all of your loss categories. Your adjusted net capital loss appears on line 21 of Worksheet B. Then take the following steps.

1. Add together the net losses (from line 17 of your foreign Schedules D) of all of your loss categories.
2. For each loss category, divide the loss from line 17 of that category's foreign Schedule D by the amount in step 1.
3. For each loss category, multiply the amount from step 2 by your adjusted net loss ( line 21 of Worksheet B). This is your adjusted net loss amount for that loss category that you include on line 5 of that category's Form 1116. The amount on line 5 of that category's Form 1116 cannot include more capital loss than the adjusted net loss amount for that category.

Gain categories. If you have foreign source capital gains from more than one separate limitation income category, take the following steps.

1. For each separate limitation income category that has a gain (or zero) on line 17 of its foreign Schedule D, complete Worksheet A in the Form 1116 instructions. Complete a separate Worksheet A for each gain category through line 14.
2. Total your adjusted foreign capital gains from line 14 of each Worksheet A. From this total subtract the total of all of your adjusted foreign source capital losses in all loss categories (which appears on line 21 of Worksheet B, as discussed under Loss categories earlier).
3. Compare the amount from step 2 to the amount on line 14 of the Worksheet for Line 17 in the Form 1116 instructions. (The foreign capital gain net income taken into account for purposes of the foreign tax credit cannot exceed your worldwide capital gain net income.)

If the amount on line 14 of the Worksheet for Line 17 is equal to or greater than the amount in step 2, no further adjustment is necessary. For each category, include the amount determined in step 1 as capital gain on line 1, Form 1116, or the amount determined under Loss categories as capital loss on line 5, Form 1116. The amount of capital gain included on line 1 of a category's Form 1116 cannot exceed the amount determined under step 1.

See Allocation of Foreign Losses and Recapture of Foreign Losses, later.

If the amount on line 14 of the Worksheet for Line 17 is less than the amount from step 2, you must allocate the difference to your gain categories. You reduce the gain for each category by an amount figured by multiplying the difference by the adjusted gain in a particular category divided by the total of all adjusted capital gains from all gain categories (not your net gain from step 2, which has been reduced by losses).

Examples. The following examples show how to make the required adjustments if you have foreign source capital gains and losses in more than one separate limitation income category.

Example 1. Your total adjusted foreign capital gain is $25,000 (determined by adding the adjusted capital gains from line 14 of your Worksheets A for each of your gain categories). All categories have gains on line 16 and line 17 of their foreign Schedules D. $5,000 is from the general limitation category. The amount on line 14 of the Worksheet for Line 17 (your adjusted worldwide net capital gain) is $22,580. Since that amount is less than the amount from step 2, you must allocate the difference, $2,420 ($25,000 - $22,580) to each of the categories. You must reduce the gain in the general limitation category by $484 ($5,000/$25,000 × $2,420). On the Form 1116 that you complete for the general limitation category, you would include $4,516 ($5,000 - $484) of your capital gain on line 1. If you had $10,000 of ordinary income (such as wages) in the general limitation category, the total amount on line 1 of that category's Form 1116 would be $14,516 ($4,516 of capital gain + $10,000 of ordinary income).

Example 2. Your total foreign loss is $5,000. It consists of a passive category loss of $2,000 and a general limitation category loss of $3,000 (as shown on line 17 of your foreign Schedules D for those categories). Assume your adjusted net capital loss (from line 21 of Worksheet B) is $2,222. For the passive category, the amount of capital loss to include on line 5 of Form 1116 is $889 ($2,000/$5,000 × $2,222).

Example 3. You have a net gain on line 17 of the Schedule D you are filing with your Form 1040. You have net foreign source capital gains in your passive separate limit category and your general limitation category (from line 17 of the foreign Schedules D for those categories). You have a net foreign source capital loss in your shipping separate limit category (shown on line 17 of your foreign Schedule D for that category).

You complete Worksheet A in the Form 1116 instructions separately for the passive and general limitation categories. The amount on line 14 of Worksheet A is $2,000 for the passive category and $3,000 for the general limitation category. Therefore, your total adjusted foreign capital gain is $5,000 ($2,000 + $3,000).

You complete Worksheet B for the shipping category, and the amount on line 21 of that worksheet is $1,000. Because the shipping category is your only loss category, all of the $1,000 adjusted foreign capital loss belongs in that category. The excess of your adjusted gains over your adjusted losses (your net adjusted capital gain) is $4,000 ($5,000 - $1,000).

Assume $1,500 appears on line 14 of the Worksheet for Line 17 in the Form 1116 instructions. This amount is less than your foreign net adjusted capital gain. The excess of your net adjusted capital gain over the amount from the Worksheet for Line 17 (your worldwide net adjusted capital gain) is $2,500 ($4,000 - $1,500). Because your foreign capital gain cannot exceed your worldwide capital gain in the foreign tax credit calculation (reflected on the Form 1116), you must allocate this $2,500 excess, as a reduction, between your foreign net capital gain categories based on the portion of your total foreign adjusted capital gain that is attributable to each category. On line 1 of your passive category Form 1116, you include $1,000 ($2,000 - ($2,500 × $2,000/$5,000)).

On line 1 of your general limitation category Form 1116, you include $1,500 ($3,000 - ($2,500 × $3,000/$5,000)).

For the shipping category, the $1,000 adjusted capital loss should be included on line 5 of the Form 1116.

Example 4. The facts are the same as in Example 3, except that line 14 of the Worksheet for Line 17 shows $6,000. This amount is more than your $4,000 foreign net adjusted capital gain, so no further adjustment is necessary. Include the $2,000, $3,000, and $1,000 amounts on the Forms 1116 for the appropriate categories.

Example 5. You have net capital losses of $3,000 in the passive separate limit category and $4,000 in the general limitation category (from line 17 of the foreign Schedules D for those categories).

You have a net capital gain of $2,000 in the shipping category (from line 17 of the foreign Schedule D for that category).

Your total foreign source capital loss is $7,000 ($3,000 + $4,000). All $7,000 is taken into account in determining worldwide capital gain net income for the year, so all $7,000 must be adjusted. You include all $7,000 on line 1 of Worksheet B in the Form 1116 instructions. Assume $4,500 is the amount on line 21 of Worksheet B. The amount to include on line 5 of your passive category Form 1116 is $1,929 ($4,500 × $3,000/$7,000). The amount to include on line 5 of your general limitation category Form 1116 is $2,571 ($4,500 × $4,000/$7,000). Complete Worksheet A in the Form 1116 instructions for your shipping category, to determine the amount of capital gain to include on line 1 of your shipping category Form 1116.

Allocation of Foreign Losses

If you have a foreign loss when figuring your taxable income in a separate limit income category, and you have income in one or more of the other separate categories, you must first reduce the income in these other categories by the loss before reducing income from U.S. sources.

Example. You have $10,000 of income in the passive income category and incur a loss of $5,000 in the general limitation income category. You must use the $5,000 loss to offset $5,000 of the income in the passive category.

How to allocate. You must allocate foreign losses among the separate limit income categories in the same proportion as each category's income bears to total foreign income.

Example. You have a $2,000 loss in the general limitation income category, $3,000 of passive income, and $2,000 in distributions from a FSC. You must allocate the $2,000 loss to the income in the other separate categories. 60% ($3,000/$5,000) of the $2,000 loss (or $1,200) reduces passive income and 40% ($2,000/$5,000) or $800 reduces FSC distributions.

Loss more than foreign income. If you have a loss remaining after reducing the income in other separate limit categories, use the remaining loss to reduce U.S. source income. When you use a foreign loss to offset U.S. source income, you must recapture the loss as explained later under Recapture of Foreign Losses.

Recharacterization of subsequent income in a loss category. If you use a loss in one separate limit category (category A) to reduce the amount of income in another category or categories (category B and/or category C) and, in a later year you have income in category A, you must, in that later year, recharacterize some or all of the income from category A as income from category B and/or category C.

Do not recharacterize the tax.

Example. The facts are the same as in the previous example. However, in the next year you have $4,000 of passive income, $1,000 in FSC distributions, and $5,000 of general limitation income. Since $1,200 of the general limitation loss was used to reduce your passive income in the previous year, $1,200 of the current year's general limitation income of $5,000 must be recharacterized as passive income. This makes the current year's total of passive income $5,200 ($4,000 + $1,200). Similarly, $800 of the general limitation income must be recharacterized as FSC distributions, making the current year's total of FSC distributions $1,800 ($1,000 + $800). The total income in the general limitation category is $3,000 ($5,000 - $1,200 - $800).

U.S. losses. Allocate any net loss from sources in the United States among the different categories of foreign income after:

1. Allocating all foreign losses as described earlier,
2. Recapturing any prior year overall foreign loss as described below, and
3. Recharacterizing foreign source income as described above.

Recapture of Foreign Losses

If you have only losses in your separate limit categories, or if you have a loss remaining after allocating your foreign losses to other separate categories, you have an overall foreign loss. If you use this loss to offset U.S. source income (resulting in a reduction of your U.S. tax liability), you must recapture your loss in each succeeding year in which you have taxable income from foreign sources in the same separate limit category. You must recapture the overall loss regardless of whether you chose to claim the foreign tax credit for the loss year.

You recapture the loss by treating part of your taxable income from foreign sources in a later year as U.S. source income. In addition, if, in a later year, you sell or otherwise dispose of property used in your foreign trade or business, you may have to recognize gain and treat it as U.S. source income, even if the disposition would otherwise be nontaxable. See Dispositions, later. The amount you treat as U.S. source income reduces the foreign source income, and therefore reduces the foreign tax credit limit.

You must establish separate accounts for each type of foreign loss that you sustain. The balances in these accounts are the overall foreign loss subject to recapture. Reduce these balances at the end of each tax year by the loss that you recaptured. You must attach a statement to your Form 1116 to report the balances (if any) in your overall foreign loss accounts.

Overall foreign loss. An overall foreign loss is the amount by which your gross income from foreign sources for a tax year is exceeded by the sum of your expenses, losses, or other deductions that you allocated and apportioned to foreign income under the rules explained earlier under Determining Taxable Income From Sources Outside the United States. But see Losses not considered, later, for exceptions.

Example. You are single and have gross dividend income of $10,000 from U.S. sources. You also have a greater-than-10% interest in a foreign partnership in which you materially participate. The partnership has a loss for the year, and your distributive share of the loss is $15,000. Your share of the partnership's gross income is $100,000, and your share of its expenses is $115,000. Your only foreign source income is your share of partnership income which is in the general limitation income category. You are a bona fide resident of a foreign country and you elect to exclude your foreign earned income. You exclude the maximum $78,000. You also have itemized deductions of $4,700 that are not definitely related to any item of income.

In figuring your overall foreign loss in the general limitation category for the year, you must allocate a ratable part of the $4,700 in itemized deductions to the foreign source income. You figure the ratable part of the $4,700 that is for foreign source income, based on gross income, as follows:

Therefore, your overall foreign loss for the year is $7,573, figured as follows:

Losses not considered. You do not consider the following in figuring an overall foreign loss in a given year.

1. Net operating loss deduction.
2. Foreign expropriation loss not compensated by insurance or other reimbursement.
3. Casualty or theft loss not compensated by insurance or other reimbursement.

Recapture provision. If you have an overall foreign loss for any tax year and use the loss to offset U.S. source income, part of your foreign source taxable income (in the same separate limit category as the loss) for each succeeding year is treated as U.S. source taxable income. The part that is treated as U.S. source taxable income is the smallest of:

1. The balance in the applicable overall foreign loss account,
2. 50% (or a larger percentage that you can choose) of your foreign source taxable income for the succeeding tax year, or
3. The foreign source taxable income for the succeeding tax year which is in the same separate limit category as the loss after the allocation of foreign losses (discussed earlier).

Example. During 2000 and 2001, you were single and a 20% general partner in a partnership that derived its income from Country X. You also received dividend income from U.S. sources during those years.

For 2000, the partnership had a loss and your share was $20,000, consisting of $100,000 gross income less $120,000 expenses. Your net loss from the partnership was $4,800, after deducting the foreign earned income exclusion and definitely related allowable expenses. This loss is related to income in the general limitation category. Your U.S. dividend income was $20,000. Your itemized deductions totaled $5,000 and were not definitely related to any item of income. In figuring your taxable income for 2000, you deducted your share of the partnership loss from Country X from your U.S. source income.

During 2001, the partnership had net income from Country X. Your share of the net income was $40,000, consisting of $100,000 gross income less $60,000 expenses. Your net income from the partnership was $8,800, after deducting the foreign earned income exclusion and the definitely related allowable expenses. This loss is related to income in the general limitation category. You also received dividend income of $20,000 from U.S. sources. Your itemized deductions were $6,000, which are not definitely related to any item of income. You paid income taxes of $4,000 to Country X on your share of the partnership income.

When figuring your foreign tax credit for 2001, you must find the foreign source taxable income that you must treat as U.S. source income because of the foreign loss recapture provisions.

You figure the foreign taxable income that you must recapture as follows:

The amount of the recapture is shown on line 15, Form 1116.

Recapturing more overall foreign loss than required. If you want to make an election or change a prior election to recapture a greater part of the balance of an overall foreign loss account than is required (as discussed earlier), you must attach a statement to your Form 1116. If you change a prior year's election, you should file Form 1040X.

The statement you attach to Form 1116 must show:

1. The percentage and amount of your foreign taxable income that you are treating as U.S. source income, and
2. The balance (both before and after the recapture) in the overall foreign loss account that you are recapturing.

Deduction for foreign taxes. You can recapture part (or all, if applicable) of an overall foreign loss in tax years in which you deduct, rather than credit, your foreign taxes. You recapture the lesser of:

1. The balance in the applicable overall foreign loss account, or
2. The foreign source taxable income of the same separate limit category that resulted in the overall foreign loss minus the foreign taxes imposed on that income.

Dispositions. If you dispose of appreciated trade or business property used predominantly outside the United States, and that property generates foreign source taxable income of the same separate limit category that resulted in an overall foreign loss, the disposition is subject to the recapture rules. Generally, you are considered to recognize foreign source taxable income in the same separate limit category as the overall foreign loss to the extent of the lesser of:

1. The fair market value of the property that is more than your adjusted basis in the property, or
2. The remaining amount of the overall foreign loss not recaptured in prior years or in the current year as described earlier under Recapture provision and Recapturing more overall foreign loss than required.

This rule applies to a disposition whether or not you actually recognized gain on the disposition and irrespective of the source (U.S. or foreign) of any gain recognized on the disposition.

The foreign source taxable income that you are considered to recognize is generally subject to recapture as U.S. source income in an amount equal to the lesser of:

1. Your foreign source taxable income in the same separate limit category as the overall foreign loss, or
2. 100% of your total foreign source taxable income for the year.

If you actually recognized foreign source gain in the same separate limit category as the overall foreign loss on a disposition of property described earlier, you must reduce the foreign source taxable income in that separate limit category by the amount of gain you are required to recapture. If you recognized foreign source gain in a different separate limit category than the overall foreign loss on a disposition of property described earlier, you are required to reduce your foreign source taxable income in that separate limit category for gain that is considered foreign source taxable income in the overall foreign loss category and subject to recapture. If you did not otherwise recognize gain on a disposition of property described earlier, you must include in your U.S. source income the foreign source taxable income you are required to recognize and recapture.

Predominant use outside United States. Property is used predominantly outside the United States if it was located outside the United States more than 50% of the time during the 3-year period ending on the date of disposition. If you used the property fewer than 3 years, count the use during the period it was used in a trade or business.

Disposition defined. A disposition includes the following transactions.

• A sale, exchange, distribution, or gift of property.
• A transfer upon the foreclosure of a security interest (but not a mere transfer of title to a creditor or debtor upon creation or termination of a security interest).
• An involuntary conversion.
• A contribution to a partnership, trust, or corporation.
• A transfer at death.
• Any other transfer of property whether or not gain or loss is normally recognized on the transfer.

The character of the income (for example, as ordinary income or capital gain) recognized solely because of the disposition rules is the same as if you had sold or exchanged the property.

However, a disposition does not include:

• A disposition of property that is not a material factor in producing income, or
• A transaction in which gross income is not realized.

Basis adjustment. If gain is recognized on a disposition solely because of an overall foreign loss account balance at the time of the disposition, the recipient of the property can increase its basis by the amount of gain deemed recognized. If the property was transferred by gift, its basis in the hands of the donor immediately prior to the gift is increased by the amount of gain deemed recognized.

Tax Treaties

The United States is a party to tax treaties that are designed, in part, to prevent double taxation of the same income by the United States and the treaty country. Many treaties do this by allowing you to treat U.S. source income as foreign source income. Certain treaties have special rules you must consider when figuring your foreign tax credit if you are a U.S. citizen residing in the treaty country. These rules generally allow an additional credit for part of the tax imposed by the treaty partner on U.S. source income. It is separate from, and in addition to, your foreign tax credit for foreign taxes paid or accrued on foreign source income. The treaties that provide for this additional credit include those with Australia, Austria, Canada, Denmark (new treaty), Finland, France, Germany, Ireland, Israel, Luxembourg (new treaty), Mexico, the Netherlands, New Zealand, Portugal, South Africa, Sweden, and Switzerland. There is a worksheet at the end of this publication to help you figure the additional credit. But do not use this worksheet to figure the additional credit under the treaties with Australia and New Zealand. Also, do not use this worksheet for income that is in the "Income re-sourced by treaty" category discussed earlier under Separate Limit Income.

You can get more information, and the worksheet to figure the additional credit under the Australia and New Zealand treaties, by writing to:

Internal Revenue Service
International Section
P.O. Box 920
Bensalem, PA 19020-8518.

You can also contact the United States Tax Attaché at the U.S. Embassies in Berlin, London, Mexico City, Paris, Rome, Singapore, and Tokyo, as appropriate, for assistance.

Report required. You may have to report certain information with your return if you claim a foreign tax credit under a treaty provision. For example, if a treaty provision allows you to take a foreign tax credit for a specific tax that is not allowed by the Internal Revenue Code, you must report this information with your return. To report the necessary information, use Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b).

If you do not report this information, you may have to pay a penalty of $1,000.

You do not have to file Form 8833 if you are claiming the additional foreign tax credit (discussed previously).