How much net passive source income goes on Form 1116 when capital losses are way over the $3,000 limitation?

Question

For U.S. tax year 2021, I have a large passive-category foreign source capital loss (mostly long-term), a medium-size domestic capital loss (mostly long-term), and a small passive category foreign source interest income, which I paid withholding tax on, per tax treaty. Numbers for purpose of example:

• $20,000 foreign source capital loss
• $10,000 domestic capital loss
• $4,000 foreign source interest income
• $400 tax was withheld on the interest income

On Schedule D, I know capital losses that can be claimed are limited to reducing ordinary income by $3,000. But on Form 1116 I don't know that any such limitation exists, and so, this is confusing me.

On form 1116, should I calculate my net passive-category foreign income as $1,000 (by limiting the amount of capital loss that offsets my foreign source interest income to $3,000), or is it actually just supposed to show a net foreign (loss) of ($16,000)? [$20,000 - $4,000]

And then what about carry-over? Do I separately compute the carry-forward amounts, for use on the different tax forms? I.e.

• Schedule D: carry-forward should be net long-term capital (loss) of ($27,000) after excluding the allowed $3,000 from 2021 income.
• Form 1116: carry-forward the net long-term foreign capital loss of ($16,000), and the entire domestic capital loss of ($10,000) for purposes of figuring carry-over and loss recaptures against future income?

Note the interesting deviation there: $27,000 would be carried forward on one form, but $26,000 on the other. Is the discrepancy of $1,000 supposed to be corrected somehow, and how?

Answer 1

In the comments you've clarified a bit about what's confusing.

Form 1116 is not reporting income, it's reporting foreign taxes you've paid and is used to calculate the foreign tax credit. And that's what you carry forward on that form. Capital gains/losses are reported on Schedule D and carried forward there as well.

As such, you report capital gains/losses, including carry-overs, on Schedule D. You report foreign tax credits, separated by source of income, and including carry-overs, on form 1116.

In your situation you have significant capital loss from foreign source and you can potentially offset it with future capital income from foreign source. That is what the article you linked to talks about. You convert the foreign gain into US gain up to the amount of the foreign loss, at the time of the gain. That foreign loss is called "foreign loss account".

If you don't have any foreign gain, then the foreign loss continues to be carried over on your Schedule D until you have enough capital gains to offset it, or until you exhaust your $3K annual allowance to deduct it from regular income.