Form 1116 and Foreign Capital Gains & Losses

Financial Planning Tax Strategies
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I have foreign tax withheld from stocks in two countries, but I have also a net long-term capital gain in one of those countries and a net long-term capital loss in the other country due to various stock sales.

I’d like to make sure that I understand the instructions for Form 1116 correctly on how to report this on this form. FWIW I am using category “Passive category income” (Box C) for my Form 1116.

  • For country A (with a positive net capital gain) is is correct to put that net capital gain in part I, field 1a of Form 1116 in the column for country A and give it the label “Long-term capital gains”?

  • For country B ( with a net capital loss) is is correct to put that net capital loss as a positive number in part I, field 5 (“Losses from foreign sources”) in the column for country B?

Thanks, so much in advance for any help on this matter.

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Is your “foreign” capital gain/loss from the sale of stocks that generate foreign dividends? If so, they are not foreign transactions.

But the first question you should ask yourself is whether you need to complete Form 1116 at all. Unless your foreign tax is >$300 ($600 if filing MFJ), you can take the foreign tax credit directly on Schedule 3.

Finally, if these truly were foreign capital transactions (say, the sale of foreign sited real estate), your approach would be correct.

Ira

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Ira,

thank you so much for your quick and thoughtful response.

Is your “foreign” capital gain/loss from the sale of stocks that generate foreign dividends? If so, they are not foreign transactions.

Yes, these gains/losses are indeed from the sale of stocks that generate foreign dividends and the companies are domiciled in those countries that I am reporting on on my Form 1116, e.g. I sold stocks in “Telefonica” (TEF.MC) a Spanish company and “Novo Nordisk” (NOVC.DE), while also receiving dividends from both of those companies. Both sales happened on a German stock exchange (and are of course also reported on Form 8949 in Turbo Tax).

So if I understand you correctly, any capital gain or loss from a stock sale of foreign stocks is NOT reportable on Form 1116, correct?

But the first question you should ask yourself is whether you need to complete Form 1116 at all. Unless your foreign tax is >$300 ($600 if filing MFJ), you can take the foreign tax credit directly on Schedule 3.

Unfortunately I believe I do need to complete this Form, because my foreign tax withholdings are above $300 (filing status “Single”). I also have some carryovers from previous years (in case that matters).

So if it were to turn out that my foreign tax credit were to be less than $300, despite tax withholding of more than $300, could I just delete the Form 1116 in TurboTax, claim the $300 credit directly on Schedule 3 and be done with it?

Finally, if these truly were foreign capital transactions (say, the sale of foreign sited real estate), your approach would be correct.

Cool, that is good to know.

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The answers you provided are moving beyond my pay grade. While I still think that the stock sales on a foreign exchange are not foreign transactions for US tax purposes, I’m not sure. I know that if the trades were executed on a US exchange, they would not be foreign activity. I suspect the true answer lies within the tax treaties between the US and Germany (since the transactions occurred there.)

However, the fact that you are above the $300 threshold AND you have foreign tax credit carryovers does have an impact on your choices. You could just eliminate the 1116 and take the $300 the same way you could ignore traffic lights and speed limits. Remember that you sign your return “under penalty of perjury”. As Baretta used to say, “Don’t do the crime if you can’t do the time.” (1970s tv reference).

Additionally, if your foreign taxes did drop below $300 in a year - you could elect not to file Form 1116, but at a price. You would lose any of the foreign tax credits that you’ve been carrying forward.

Ira

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The answers you provided are moving beyond my pay grade. While I still think that the stock sales on a foreign exchange are not foreign transactions for US tax purposes, I’m not sure.

Ira, that’s fair enough. I do appreciate very much that you’re willing to go out on a limb (and saying so). I did something dangerous for a non-expert and that is doing some more googling and I found “26 U.S. Code § 865 - Source rules for personal property sales”: https://www.law.cornell.edu/uscode/text/26/865
I hope I’m correct in assuming that this is the applicable section.

I know that if the trades were executed on a US exchange, they would not be foreign activity. I suspect the true answer lies within the tax treaties between the US and Germany (since the transactions occurred there.)

Subsection (h), 2, A of that code above indeed appears (to my non-trained eye) to cover certain sale of stocks in a foreign corporation. Bullet point ii is referring to tax treaty and bullet point iii appears to say that I can choose whether to apply this subsection or not.

I did look at the tax treaty between the U.S. and Germany ( https://www.irs.gov/businesses/international-businesses/germ… ), the 2006 protocol and the technical explanation.

The pertinent section in the treaty itself appears to be Article 13, paragraph 5: “Gains from the alienation of any property other than that referred to in the preceding paragraphs shall be taxable only in the Contracting State of which the alienator is a resident.”

Note: Those preceding paragraphs mentioned in the quote covered immovable property (real estate), business property of an enterprise and sale of ships aircraft, and containers and obviously don’t apply here.

And indeed Germany does NOT tax my capital gains, unlike the capital gains of a resident of Germany.

As an aside the question of “source” is addressed very rarely, generally the focus is on “taxable”.

However, the fact that you are above the $300 threshold AND you have foreign tax credit carryovers does have an impact on your choices. You could just eliminate the 1116 and take the $300 the same way you could ignore traffic lights and speed limits. Remember that you sign your return “under penalty of perjury”. As Baretta used to say, “Don’t do the crime if you can’t do the time.” (1970s tv reference).

Additionally, if your foreign taxes did drop below $300 in a year - you could elect not to file Form 1116, but at a price. You would lose any of the foreign tax credits that you’ve been carrying forward.

Yeah, I prefer not to go out too far on a limb, so ignoring the 1116 and claiming the $300 is then obviously not an option. And I don’t foresee that my foreign taxes will drop below $300 in the foreseeable future, so Form 1116 it is and will be. :frowning:

Ira, at this point though it seems to me that your intuition is indeed correct that these stock sales are NOT foreign source transactions for U.S. tax purposes. But if you see any read (or even yellow) flags in this logic, please do not hesitate to say so.

Thanks again,
Bernhard

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Bernhard,

Section 865 appears to be the relevant code for US treatment of the stock sales, but I am not going to venture into interpreting what the section actually says.

Good luck. Perhaps one of the other resident tax experts has more experience in this area.

Ira

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