The Form 1116 capital gains tax adjustment scales down foreign-source long-term capital gains and qualified dividends before they enter the Foreign Tax Credit limitation fraction. You multiply each block of preferential-rate foreign income by a fixed factor tied to the U.S. rate that applies to it: 0 for the 0% bracket, 0.4054 for the 15% rate, 0.5405 for the 20% rate, 0.6757 for unrecaptured Section 1250 gain at 25%, and 0.7568 for collectibles at 28%.1Internal Revenue Service. Foreign Tax Credit Compliance Tips The reduced amount goes on Line 1a. Skip the adjustment and you overstate the credit, which is one of the errors the IRS flags most often on international returns.
The reason the adjustment exists is simple arithmetic. The credit is capped at U.S. tax attributable to foreign income, computed as foreign-source taxable income over worldwide taxable income, times total U.S. tax.2Internal Revenue Service. About the Foreign Tax Credit Preferential-rate income is taxed well below the 37% top ordinary rate, so plugging in the full dollar amount inflates the numerator and the credit. Each factor above is that preferential rate divided by 37%.
Which Income Gets Adjusted
Five types of foreign-source income trigger the adjustment: long-term capital gains, qualified dividends, unrecaptured Section 1250 gain, Section 1231 gains, and collectibles gains.1Internal Revenue Service. Foreign Tax Credit Compliance Tips For most individual investors, that means qualified dividends from foreign stocks, long-term gains on foreign shares, and distributions from foreign mutual funds. Gain on foreign rental property recaptured at 25% and collectibles gain at 28% show up less often but follow the same mechanic.
Short-term foreign gains are taxed at ordinary rates, so they don’t get adjusted. They go onto Line 1a at their full amount.
Confirm the Gain Is Actually Foreign Source
Owning a foreign stock does not make the gain from selling it foreign source. Under the general rule, gain from a U.S. resident’s sale of personal property is sourced in the United States regardless of where the company is incorporated or where the asset sits.3Office of the Law Revision Counsel. 26 US Code 865 – Source Rules for Personal Property Sales Narrow exceptions apply when a foreign corporation actively conducts business in the country where the sale occurs and derives more than half its gross income from active business there over the preceding three years, or when a treaty re-sources the gain. For a U.S. investor selling foreign shares through a brokerage, the capital gain is almost certainly U.S. source and never touches Form 1116.
Qualified dividends from a foreign corporation, by contrast, are generally foreign source. The same stock can produce foreign-source dividends and U.S.-source capital gains, so treat them separately.
Pick the Right Factor
The factor depends on the U.S. rate that applies to that slice of income. To find the rate, run the Qualified Dividends and Capital Gain Tax Worksheet in the Form 1040 instructions first. That worksheet stacks your preferential-rate income into the 0%, 15%, and 20% brackets based on total taxable income.4Internal Revenue Service. Instructions for Form 1116 If your foreign gains straddle two brackets, split them at the bracket boundary and apply the matching factor to each piece.
- 0% rate: multiply by 0. The income drops out entirely and generates no credit.
- 15% rate: 0.4054. The common case for most individual investors.
- 20% rate: 0.5405. Applies once taxable income exceeds the 20% threshold ($545,500 for single filers in 2026).
- 25% rate: 0.6757. Unrecaptured Section 1250 gain on depreciable real property.
- 28% rate: 0.7568. Collectibles gain.
Do the split by rate group first, then multiply. Combining rates before applying a factor produces the wrong number.
A Worked Example
Say you have $12,000 of foreign-source qualified dividends in the Passive category, all falling in the 15% bracket, plus $5,000 of foreign-source unrecaptured Section 1250 gain at 25%.
- Qualified dividends: $12,000 × 0.4054 = $4,865.
- Unrecaptured Section 1250 gain: $5,000 × 0.6757 = $3,379.
The numerator of the limitation fraction picks up $8,244 instead of the raw $17,000. That gap is exactly what keeps the credit tied to the U.S. tax those items actually generate.
If part of the $12,000 fell in the 0% bracket and the rest in the 15% bracket, you’d multiply the 0% slice by zero and the 15% slice by 0.4054, then add.
Where the Adjusted Numbers Go
Adjusted amounts land on Line 1a of Part I of the Form 1116 for the matching category. The Foreign Tax Credit uses separate limitation baskets, and you file a separate Form 1116 for each.5Office of the Law Revision Counsel. 26 US Code 904 – Limitation on Credit Most individuals only touch two: Passive Category (dividends, interest, rents, royalties, and investment capital gains) and General Category (wages, self-employment income, and active foreign business income).6eCFR. 26 CFR 1.904-4 – Separate Application of Section 904 With Respect to Certain Categories of Income Run the adjustment independently inside each basket that contains preferential-rate income.
Combine the adjusted preferential-rate income with any unadjusted ordinary foreign income for that basket on Line 1a. If a Passive Form 1116 carries $20,000 of foreign interest plus the $4,865 of adjusted dividends from the example, Line 1a shows $24,865. Lines 2 through 5 apportion deductions and expenses. Line 7 becomes the foreign-source taxable income that feeds the fraction in Part III, where Line 19 produces the credit limit for that category.4Internal Revenue Service. Instructions for Form 1116
One related step often gets missed: the Line 18 worksheet requires a parallel adjustment to worldwide taxable income in the denominator, using a separate set of factors in the Form 1116 instructions. Both adjustments have to be done together so the fraction reflects preferential rates on both sides.
When You Can Skip This Entirely
You can claim the Foreign Tax Credit directly on Form 1040 without filing Form 1116, and therefore without doing this adjustment at all, if three conditions are met: every dollar of your foreign-source gross income is passive category income, all of it was reported on a qualified payee statement such as a Form 1099-DIV or 1099-INT, and your total creditable foreign taxes for the year are $300 or less ($600 if married filing jointly).4Internal Revenue Service. Instructions for Form 1116 Once you cross the dollar threshold or pick up any non-passive foreign income, Form 1116 and the adjustment come back into play.