Form 1116 Line 3a - Real Estate Tax - LIMITED?

[JimS_1]

In processing a 2019 tax return, we had a client that had real estate taxes of 7k and state income taxes of 19k, for a total of 26k taxes paid, and was limited to 10k on Schedule A.  That's fine, but in the Foreign Tax Credit Form 1116, line 3a, Lacerte did not put in 7k from Schedule A.  Instead, it calculated 27% (7k RE tax / 26k all tax) and then multiplied by the 10k total tax on Schedule A, so only $2.7k was deducted from foreign income.

Instructions for Form 1116 do not reference any limitation required for this line.  NOTE:  When I reviewed 2017 Form 1116 instructions it DOES require a reduction to line 3a because of the income limitation on Schedule A that was in effect prior to the TJCA. 

Is Lacerte calculating this correctly?

[itonewbie]

Scratch that. Misread question. Will respond again.

[itonewbie]

Can you give a break down of the Sch A numbers, what was allowed, and whether there are deductions that are definitively related to US income or certain basket on Line 2?

Also, is your client a tax resident of a state where worldwide income is subject to state tax?

[JimS_1]

The taxpayer had 16k of medical expenses, but was not able to claim any due the 7.5% floor.  The state and local taxes were just 19k of state income taxes (New Jersey) and the $7k Real Estate taxes - both of which were limited to 10k.  The taxpayer had 62k of Charitable cash gifts (not limited).  Total itemized was 72k, which was taken fully.   On line 2 of Form 1116, there are no amounts listed.   Foreign income is 4k from RIC and 2k from a K-1 (trust).   Taxpayer is resident of NJ, which I'm pretty sure requires taxes paid on the foreign income.    

Appreciate your help!!  The reason this came up is this is a new client and previous tax preparer (Big 4) included full 10k in line 3a, but when we input prior year data in 2019 so we can rollforward to 2020, Lacerete did not include the full 10k.  It seems like Lacerete is making an assumption that just like pre-TJCA required a reduction for limited deductions, that the software should also reduce the RE taxes for the SALT limitation post-TJCA.  But 2019 Form 1116 instructions do not say this has to be limited.

[itonewbie · Accepted solution]

This is easy to explain and that's the reason why I asked about your client's residency.

Since your client is a tax resident in a state and is presumably subject to state tax on worldwide income, state income tax deduction is ratably allocable to gross income from all sources.  Lacerte wouldn't know that but you should see that it does trigger an informational diagnostic to prompt you to consider the sourcing position (if you had checked).

The way to solve this is to take the following steps:

1. Go to Screen 35.1;
2. Under Sections in the bottom left panel, click on Deductions and Losses;
3. On the line for Other deductions not directly allocable [A], hit Ctrl+E to pull up the dialog box; and
4. Enter NJ Income Tax Deduction (or something to that effect) under Description, enter 7,308 under Amount, and select NJ under State.

This $7,308 will show up on Line 3b and increase Line 3c to $10,000.

[JimS_1]

AHHH!  I wasn't thinking about allocating the state income tax....  That makes sense!  Lacerte doesn't know the RE taxes don't need to be allocated.   Got it.  Thank you so much for the education!!!  Much appreciated.

[itonewbie]

R/E tax needs to be allocated and that's the default.  What Lacerte doesn't know is whether and how state income tax should be allocated.

[JimS_1]

Actually...

The instructions for line 3a say that it should be the sum of three things: "Medical Expenses", "General Sales Tax" and "Real estate taxes for your home".    It does not allow for any deduction for State "Income Tax".   Lacerte knows that we are using Income taxes in Line 5a of Sch A (Screen 25) and not sales taxes

So it shouldn't need to allocate any of this line to foreign.

I'm thinking it should just be the $7k real estate taxes that show up on line 3a to match the instructions.

Line 3b says it's for any other deductions that don't relate to income (for which the taxpayer doesn't have any).  So I think 3b should be blank.  (Although, based on that description in the instructions, I could argue that 3b could be the deduction for charitable contributions since that is not related to income... but that might be pushing it.)

Does this make sense? Or am I just lost... 😞

[JimS_1]

Oh boy - I missed the instructions for Lines 2 through 5 - where it says "A ratable share of your other deductions that don't definitely relate to that foreign income"....  Hmmm... Now I'm wondering if Lacerte is right that it should just be the 2,7k, as that is a ratable share of the $10k deduction....  And the previous prepare was wrong.

Sorry I'm going in circles on this...

[itonewbie]

The return prepared by Big 4 is correct.  That's how sourcing should be done in accordance with §861 and its regs, which are very detailed and technical.

[itonewbie]

What you said about charitable contributions is not correct.  See §1.861-8(e)(12).

[itonewbie]

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@JimS_1 wrote:

Actually...

The instructions for line 3a say..

Does this make sense? Or am I just lost... 😞

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Filing instructions are not authoritative.  And because these are written for general consumption, they tend to miss out important technical details on more complex topics.  That's why you read the Code, Regs, RR, CCM, Preambles, caselaw, JCT reports, etc. instead of only filing instructions and pubs, which are far easier to digest but much lighter in contents.

If you want to go into the technical details and there is a lot even for that one section, read the Code and the Regs under §861 as suggested.  Once you understand those technicalities, all these will start to make sense.

[JimS_1]

Thank you and I appreciate your patience with me.  I have a lot to learn (and read!).  Take care!

[itonewbie]

NP, @JimS_1!  Have a great weekend!