State income taxes.   State income taxes (and certain taxes measured by taxable income) are definitely related and allocable to the gross income on which the taxes are imposed. If state income tax is imposed in part on foreign source income, the part of your state tax imposed on the foreign source income is definitely related and allocable to foreign source income.

Foreign income not exempt from state tax.   If the state does not specifically exempt foreign income from tax, the following rules apply.

1. If the total income taxed by the state is greater than the amount of U.S. source income for federal tax purposes, then the state tax is allocable to both U.S. source and foreign source income.
2. If the total income taxed by the state is less than or equal to the U.S. source income for federal tax purposes, none of the state tax is allocable to foreign source income.

Foreign income exempt from state tax.   If state law specifically exempts foreign income from tax, the state taxes are allocable to the U.S. source income.

Example.   Your total income for federal tax purposes, before deducting state tax, is $100,000. Of this amount, $25,000 is foreign source income and $75,000 is U.S. source income. Your total income for state tax purposes is $90,000, on which you pay state income tax of $6,000. The state does not specifically exempt foreign source income from tax. The total state income of $90,000 is greater than the U.S. source income for federal tax purposes. Therefore, the $6,000 is definitely related and allocable to both U.S. and foreign source income.

Assuming that $15,000 ($90,000 - $75,000) is the foreign source income taxed by the state, $1,000 of state income tax is apportioned to foreign source income, figured as follows:

$15,000 $90,000

×

$6,000

=

$1,000

Deductions not definitely related.   You must apportion to your foreign income in each separate limit category a fraction of your other deductions that are not definitely related to a specific class of gross income. If you itemize, these deductions are medical expenses, charitable contributions, and real estate taxes for your home. If you do not itemize, this is your standard deduction. You should also apportion any other deductions that are not definitely related to a specific class of income, including deductions shown on Form 1040, lines 23-33a.

The numerator of the fraction is your gross foreign income in the separate limit category, and the denominator is your total gross income from all sources. For this purpose, gross income includes income that is excluded under the foreign earned income provisions.

Itemized deduction limit.   For 2002, you may have to reduce your itemized deductions on Schedule A (Form 1040) if your adjusted gross income is more than $137,300 ($68,650 if married filing separately). This reduction does not apply to medical and dental expenses, casualty and theft losses (other than losses of employee property), gambling losses, and investment interest.

You figure the reduction by using the Itemized Deductions Worksheet in the instructions for Schedule A ( Form 1040). Line 3 of the worksheet shows the total itemized deductions subject to the reduction. Line 9 shows the amount of the reduction.

To determine your taxable income from sources outside the United States, you must first divide the reduction ( line 9 of the worksheet) by the itemized deductions subject to the reduction ( line 3 of the worksheet). This is your reduction percentage. Then, multiply each itemized deduction subject to the reduction by your reduction percentage. Subtract the result from the itemized deduction to determine the amount you can allocate to income from sources outside the United States.

Example.   You are single and have an adjusted gross income of $150,000. This is the amount on line 5 of the worksheet. Your itemized deductions subject to the reduction total $20,000. This is the amount on line 3 of the worksheet. Reduce your adjusted gross income (line 5) by $137,300. Enter the result ($12,700) on line 7. The amount on line 8 is $381($12,700 × 3%). This amount is also entered on line 9.

You have a charitable contribution deduction of $12,000 shown on Schedule A (Form 1040) that is subject to the reduction. Your reduction percentage is 1.9% (381 / $20,000). You must reduce your $12,000 deduction by $228 (1.9% × $12,000). The reduced deduction, $11,772 ($12,000 - $228), is used to determine your taxable income from sources outside the United States.

Treatment of personal exemptions.   Do not take the deduction for personal exemptions, including exemptions for dependents, in figuring taxable income from sources outside the United States.

Capital Gains and Losses

If you have capital gains (including any capital gain distributions) or capital losses, you may have to make certain adjustments to those gains or losses before taking them into account on line 1 (gains), line 5 (losses), or line 17 (taxable income before subtracting exemptions) of Form 1116.

Lines 1 and 5.   If you have foreign source capital gains or losses, you may be required to make certain adjustments to those foreign source capital gains or losses before you take them into account on line 1 or line 5 of Form 1116. You may use the instructions in this publication to determine the adjustments you must make. You may use the instructions under Foreign Capital Gains and Losses in the instructions for Form 1116 instead of the instructions in this publication if either:

1. You do not file a Schedule D (Form 1040) or Schedule D (Form 1041) with your tax return, or
2. You meet all of the following conditions.
   1. You have foreign source capital gains or losses in less than 3 separate categories.
   2. You have no U.S. or foreign source capital gains in the 25% group. (You have a capital gain in this group if you entered an amount on line 13 of the Unrecaptured Section 1250 Gain Worksheet you completed for your Schedule D.)
   3. You have no U.S. or foreign source capital gains or losses in the 28% group. (You have a capital gain or loss in this group if you entered an amount on lines 8 through 14 of column (g) of your Schedule D (Form 1040) (lines 6 through 11 of column (g) of Schedule D (Form 1041).)

If you choose not to use the instructions in this publication or in the instructions to Form 1116, see section 904(b)(2) of the Internal Revenue Code and the related regulations to determine the adjustments you must make. If you choose to use the instructions in this publication, see Adjustments to Foreign Source Capital Gains and Losses below to determine the adjustments you must make.

Line 17 (Form 1116).   If you have U.S. or foreign source capital gains, you may be required to adjust the amount you enter on line 17 of Form 1116. Use the instructions for line 17 in the Instructions for Form 1116 to determine whether you are required to make an adjustment and to determine the amount of the adjustment.

Adjustments to Foreign Source Capital Gains and Losses

You may have to make the following adjustments to your foreign source capital gains and losses.

• U.S. capital loss adjustment.
• Capital gain rate differential adjustment.

Before you make these adjustments, you must reduce your net capital gain by the amount of any gain you elected to include in investment income on line 4e of Form 4952, Investment Interest Expense Deduction. Your net capital gain is the excess of your net long-term capital gain for the year over any net short-term capital loss for the year. U.S. capital loss adjustment.   You must adjust the amount of your foreign source capital gains to the extent that your foreign source net capital gain exceeds the amount of your worldwide net capital gain (the U.S. capital loss adjustment).

Your foreign source net capital gain is the amount of your foreign source capital gains in excess of your foreign source capital losses. If your foreign source capital gains do not exceed your foreign source capital losses, you do not have a foreign source net capital gain and you do not need to make the U.S. capital loss adjustment.

Your worldwide net capital gain is the amount of your worldwide (U.S. and foreign) capital gains in excess of your worldwide (U.S. and foreign) capital losses. If your worldwide capital losses equal or exceed your worldwide capital gains, your worldwide net capital gain is zero.

Your U.S. capital loss adjustment is the amount of your foreign source net capital gain in excess of your worldwide net capital gain. (If the amount of your foreign source net capital gain does not exceed the amount of your worldwide net capital gain, you do not have a U.S. capital loss adjustment.) If you have a U.S. capital loss adjustment, you must reduce your foreign source capital gains by the amount of the U.S. capital loss adjustment. The method you use to reduce your foreign source capital gains will differ depending on whether or not you qualify for the rate differential adjustment exception.

Rate differential adjustment exception.   You qualify for the rate differential exception if:

• Line 16 or line 17 of the Schedule D (Form 1040) (or line 13 or 16 of the Schedule D (Form 1041)) you are filing with your tax return is zero or a loss; or
• If you completed Part IV of Schedule D (Form 1040), either line 24 is smaller than line 26 or line 39 is the same as or smaller than line 38. (For estates and trusts, if you completed Part V of Schedule D (Form 1041), either line 22 is smaller than line 24 or line 37 is the same as or smaller than line 36); or
• If you completed the Schedule D Tax Worksheet in the instructions for Schedule D (Form 1040 or Form 1041), either line 13 is smaller than line 11 or line 36 is the same as or smaller than line 35.

If you qualify for the rate differential adjustment exception, you must apportion the U.S. capital loss adjustment among your separate categories that have a net capital gain. A separate category has a net capital gain if the amount of foreign source capital gains in the separate category exceeds the amount of foreign source capital losses in the separate category. You must apportion the U.S. capital loss adjustment pro rata based on the amount of net capital gain in each separate category.

Example 1.   Alfie has a $300 foreign source capital gain in the passive category, a $1,000 foreign source capital gain in the general limitation category, a $400 foreign source capital loss in the general limitation category, and a $150 U.S. source capital loss. He figures his net gains and U.S. capital loss adjustment as follows.

	Foreign source net capital gain = $900  (($1,000 + $300) - $400)
	Worldwide net capital gain = $750  (($1,000 + $300) - ($400 + $150))
	U.S. capital loss adjustment = $150  ($900 - $750)

passive category and the general limitation category based on the amount of net capital gain in each separate category.

$50 apportioned to passive category    ($150 × $300/$900)
	Alfie reduces his $300 net capital gain in the passive category by $50 and includes the resulting $250 on line 1 of the Form 1116 for the passive category.
$100 apportioned to general limitation category    ($150 × $600/$900)
	Alfie reduces his $600 of net capital gain in the general limitation category by $100 and includes the resulting $500 on line 1 of the Form 1116 for the general limitation category.

Rate differential adjustment exception not met.   If you do not qualify for the rate differential adjustment exception, you must apportion the U.S. capital loss adjustment among each capital gain rate group in each separate category (a separate category capital gain rate group) that has a net capital gain. You must apportion the U.S. capital loss adjustment pro rata based on the amount of your net capital gain in each separate category capital gain rate group.

The capital gain rate groups are the short-term capital gain rate group, the 28% capital gain rate group, the 25% capital gain rate group, and the 20% capital gain rate group. A capital gain or loss is in the 28% capital gain rate group if the gain or loss is entered on lines 8 through 14 of column (g) of your Schedule D (Form 1040) (lines 6 through 11 of column (g) of Schedule D (Form 1041)). A capital gain is in the 25% capital gain rate group if it is included in the amount shown on line 13 of the Unrecaptured Section 1250 Gain Worksheet you completed for your Schedule D. A capital gain or loss is in the 20% capital gain rate group if it is a long-term capital gain or loss that is not in the 28% or 25% capital gain rate group.

You have a net capital gain in a separate category capital gain rate group if the amount of your foreign source capital gains in that separate category capital gain rate group exceeds the amount of your foreign source capital losses in that separate category capital gain rate group. If the amount of your foreign source capital losses in the separate category capital gain rate group exceeds the amount of your foreign source capital gains in the separate category capital gain rate group, you have a net capital loss in the separate category capital gain rate group.

Example 2.   Dennis has a $200 foreign source 20% capital loss in the passive category, a $100 foreign source 28% capital gain in the passive category, a $700 foreign source 20% capital gain in the general limitation category, a $300 foreign source 20% capital loss in the general limitation category, and a $250 U.S. source capital loss. Dennis' foreign source net capital gain is $300 (($100 + $700) - ($200 + $300)). Dennis' worldwide net capital gain is $50 (($100 + $700) - ($200 + $300 + $250)). Dennis' U.S. capital loss adjustment is $250 ($300 - $50). Dennis does not qualify for the rate differential adjustment exception. This amount must be apportioned among the separate category capital gain rate groups that have a net capital gain. The amount apportioned to the 28% capital gain rate group in the passive category is $50 ($250 × $100/($100 + ($700 - $300))). Dennis reduces his $100 of 28% net capital gain in the passive category by $50. The amount apportioned to the 20% capital gain rate group in the general limitation category is $200 ($250 × $400/($100 + ($700 - $300))). Dennis reduces his $400 of 20% net capital gain in the general limitation category by $200.

Capital gain rate differential adjustment.   After you have made your U.S. capital loss adjustment, if any, you are generally required to make additional adjustments (capital gain rate differential adjustments) to your foreign source capital gains and losses. However, you do not need to make the capital gain rate differential adjustments if you qualified for the rate differential adjustment exception above under U.S. capital loss adjustment.

If you did not qualify for the rate differential adjustment exception, you are required to make a capital gain rate differential adjustment for each separate category capital gain rate group that has a net capital gain or loss. See U.S. capital loss adjustment, earlier, for instructions on how to determine whether you have a net capital gain or loss in a separate category capital gain rate group and to determine the amount of any U.S. capital loss adjustment you must make before you make your capital gain rate differential adjustments.

How to make the adjustment.   How you make the capital gain rate differential adjustment depends on whether you have a net capital gain or net capital loss in a separate category capital gain rate group.

Net capital gain in a separate category capital gain rate group.   If you have a net capital gain in a separate category capital gain rate group, you make the capital gain rate differential adjustment by doing the following.

• For each separate category that has a net capital gain in the 20% capital gain rate group, multiply the amount of the net capital gain by 0.5181.
• For each separate category that has a net capital gain in the 25% capital gain rate group, multiply the amount of the net capital gain by 0.6477.
• For each separate category that has a net capital gain in the 28% capital gain rate group, multiply the amount of the foreign source net capital gain by 0.7254.

Include the results on line 1 of the applicable Form 1116. No adjustment is required if you have a net capital gain in a short-term capital gain rate group. Include the amount of net capital gain in any separate category short-term capital gain rate group on line 1 of the applicable Form 1116 without adjustment.

Example 3.   The facts are the same as Example 2. After making the U.S. capital loss adjustment, Dennis has $50 of 28% net capital gain in the passive category and $200 of 20% net capital gain in the general limitation category. Dennis includes $36.27 ($50 × 0.7254) of 28% capital gain in the amount he enters on line 1 of the Form 1116 for the passive category. Dennis includes $103.62 ($200 × 0.5181) of 20% capital gain in the amount he enters on line 1 of the Form 1116 for the general limitation category.

Net capital loss in a separate category capital gain rate group.   If you have a net capital loss in a separate category capital gain rate group, you must do the following.

1. First determine the capital gain rate group of the capital gain offset by that net capital loss. See How to determine the capital gain rate group of the capital gain offset by the net capital loss, next.
2. Then make the capital gain rate differential adjustment. See Capital gain rate differential adjustment for net capital loss, later.

How to determine the capital gain rate group of the capital gain offset by the net capital loss.   Use the following ordering rules to determine the capital gain rate group of the capital gain offset by the net capital loss.

Determinations under the following ordering rules are made after you have taken into account any U.S. capital loss adjustment. However, determinations under the following ordering rules do not take into account any capital gain rate differential adjustments that you made to any net capital gain in a separate category capital gain rate group.

Step 1.   Net capital losses from each separate category capital gain rate group are netted against net capital gains in the same capital gain rate group in other separate categories. This is done ratably to the extent that net capital gains or losses in a particular capital gain rate group occur in two or more separate categories.

Step 2.   U.S. source capital losses are netted against U.S. source capital gains in the same capital gain rate group.

Step 3.   Net capital losses from each separate category capital gain rate group in excess of the amount netted against foreign source net capital gains in Step 1 are netted against your remaining foreign source net capital gains and your U.S. source net capital gains as follows.

1. First, against U.S. source net capital gains in the same capital gain rate group, and
2. Next, against net capital gains in other capital gain rate groups (without regard to whether such net capital gains are U.S. or foreign source net capital gains) as follows.
   1. A foreign source net capital loss in the short-term capital gain rate group is first netted against any net capital gain in the 28% capital gain rate group, then against any net capital gain in the 25% capital gain rate group, and finally against any net capital gain in the 20% capital gain rate group.
   2. A foreign source net capital loss in the 28% capital gain rate group is netted first against any net capital gain in the 25% capital gain rate group, and then against any net capital gain in the 20% capital gain rate group.
   3. A foreign source net capital loss in the 20% capital gain rate group is first netted against net capital gain in the 28% capital gain rate group, and then against net capital gain in the 25% capital gain rate group.

The net capital losses in any separate category capital gain rate group are treated as coming pro rata from each separate category that contains a net capital loss in that capital gain rate group to the extent netted against:

• Net capital gains in any other separate category under Step 1,
• Any U.S. source net capital gain under Step 3(1), or
• Net capital gains in any other capital gain rate group under Step 3(2).

Capital gain rate differential adjustment for net capital loss.   After you have determined the capital gain rate group of the capital gain offset by the net capital loss, you make the capital gain rate differential adjustment by doing the following.

• To the extent that a net capital loss in a separate category capital gain rate group offsets capital gain in the 20% capital gain rate group, multiply that amount of the net capital loss by 0.5181.
• To the extent that a net capital loss in a separate category capital gain rate group offsets capital gain in the 25% capital gain rate group, multiply that amount of the net capital loss by 0.6477.
• To the extent that a net capital loss in a separate category capital gain rate group offsets capital gain in the 28% capital gain rate group, multiply that amount of the capital loss by 0.7254.

Include the results on line 5 of the applicable Form 1116. Example 4.   The facts are the same as Example 2. Dennis has a $200 20% net capital loss in the passive category. Under Step 1, the $200 capital loss offsets $200 of Dennis' 20% net capital gain in the general limitation category that remains after Dennis makes his U.S. capital loss adjustment. Dennis includes $103.62 ($200 × 0.5181) of 20% capital loss in the amount he enters on line 5 of the Form 1116 for the passive category.

Example 5.   Dawn has a $20 net capital loss in the 20% capital gain rate group in the passive category, a $40 net capital loss in the 20% capital gain rate group in the general limitation category, a $50 U.S. source net capital gain in the 20% capital gain rate group, and a $50 net capital gain in the 28% capital gain rate group in the passive category. Of the total $60 of foreign source net capital losses in the 20% capital gain rate group, $50 is treated as offsetting the $50 U.S. source net capital gain in the 20% capital gain rate group. (See Step 3(1).) Of this amount, $16.67 ($50 × $20/$60) is treated as coming from the passive category and $33.33 ($50 × $40/$60) is treated as coming from the general limitation category. The remaining $10 of foreign source net capital losses in the 20% capital gain rate group ($3.33 in the passive category and $6.67 in the general limitation category) are treated as offsetting net capital gain in the 28% capital gain rate group. (See Step 3(2)(c).) Dawn includes $11.06 of capital loss in the amount she enters on line 5 of Form 1116 for the passive category. This is $8.64 ($16.67 × 0.5181) plus $2.42 ($3.33 × 0.7254). Dawn includes $22.11 of capital loss in the amount she enters on line 5 of Form 1116 for the general limitation category. This is $17.27 ($33.33 × 0.5181) plus $4.84 ($6.67 × 0.7254). Dawn also includes $36.27 ($50 × 0.7254) of capital gain in the amount she enters on line 1 of Form 1116 for the passive category.

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