When buying a home is a forex transaction
Hi, it’s Phil Hodgen again. Welcome to the Friday Edition. This week’s episode is coming from Wall Street. (Well, technically the intersection of Water Street and Wall Street.) I’m here to give a presentation to the New York State Society of Certified Public Accountants on expatriation.
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When buying a home is really a forex trade
This week I am highlighting an “interesting” situation, where Americans living abroad can run into the Pain Factory. You are a U.S. citizen living in France. You have lived in France for 20 years, and expect to live in France for the rest of your life. You can break even (or lose money) on the sale of your house, yet have taxable income because of the impact of currency exchange rate shifts on your mortgage. Here is a vastly simplified situation:Buy a house for €1,000,000
You want to buy a house in France for €1,000,000. You borrow €1,000,000 from a French bank. The bank mortgage calls for interest payments only. You never pay principal. When you buy the house, €1 = US$1.40.
Sell the house for €1,000,000
Later, you sell the house for €1,000,000. You make no profit on the sale. The mortgage balance is still €1,000,000 — it was an interest-only loan, remember? When you sell the house, €1 = US$1.
The result?
In Euros, you are right where you started. You started with no money and no house, and ended with no money and no house. The U.S. tax result, however, is galling. The IRS says you made US$400,000 on a currency trade, and you will be required to pay U.S. income tax on that forex gain.Two things to understand
There are two key concepts that you need to understand in order to have any hope of understanding tax logic.Functional currency
The first concept is that of a taxpayer’s “functional currency”. Your income tax obligations have to be figured out in your “functional currency”. 26 U.S.C. §985(a). For humans buying a house to live in, the rule is simple. Your functional currency will be U.S. dollars. T. Regs. §1.989(a)-1(c).Foreign currency is not money
The second key concept to understand is that the IRS does not think of foreign currency as money. It is a “thing”. Personal property, to be legally precise. As you walk through the example with me, imagine that you are participating in a giant barter transaction, not using money at all to buy a house.The purchase, deconstructed
When you bought the house, you thought you borrowed some Euros and bought the house with those Euros. The IRS thinks something else happened. The IRS agrees that you bought a house, but also thinks that a second transaction happened simultaneously. The IRS thinks you:- engaged in a currency trade (you bought Euros) then
- exchanged those Euros for a house.
- €1,000,000 x US$1.40/€1 = US$1,400,000
The house sale
The IRS sees two transactions occurring: the real estate transaction, and the currency trade. First, we look at the real estate transaction. The IRS does not want to hear about Euros. Your capital gain or loss is computed in your functional currency — the U.S. Dollar. When you bought the house, you bought it for US$1,400,000. At that time, one Euro was worth you US$1.40. When you sold the house, you received US$1,000,000, because one Euro was worth US$1.00. From the U.S. tax point of view, you lost US$400,000. Unfortunately, this is a capital loss that you cannot take on your U.S. tax return. You cannot claim a capital loss on sale of your primary residence.The mortgage repayment
The second transaction is the mortgage: you borrowed Euros and paid them back. This is a currency trade, as far as the IRS is concerned. It is a short sale.- The dollar value of the mortgage you took out when you bought the house was US$1,400,000 (€1 = US$1.40).
- The dollar value of the €1,000,000 you repaid was US$1,000,000 (€1 = US$1.00).
In the example above of the $400k gain from the repayment of the mortgage, is this capital gain or ordinary? What’s the IRS position on this?
Phil, what else in the everyday life of an American living abroad could be considered a forex transaction worthy of reporting on a tax return?
Every time I use my credit card my bank is lending me Canadian dollars. Should I be calculating the U.S. dollar equivalent of every purchase on the purchase date and then compare the sum to the U.S. dollar equivalent of my payment (always in full) on the payment date? In years when the exchange rate moves up and down this could net out close to zero. But in years when the exchange rate moves mostly in one direction there could be a gain (or loss) a little too big to ignore.
What about routine transactions in a checking account? Salary in. Checks and cash out to pay for ordinary household expenses (not investments or loan repayments). The exchange rate could be different on the dates of the inflows and outflows. Is there a gain (or loss) to consider here even though the two transactions — trade labor for Canadian dollars and then trade Canadian dollars for groceries — are not with the same counterparty as in the loan example?
@DRW
Thanks for the comment. I agree that converting to investment property is a good strategy.
But really. The reason this is a problem is because of citizenship-based taxation. The United States wants a piece of you if you are living abroad.
Then the Internal Revenue Code indiscriminately applies currency exchange taxation rules to humans and multi-billion dollar enterprises indiscriminately. This is the hallmark of a broken system. What makes sense when $100,000,000 is on the line does not make sense when the amount in question is $100,000.
Good article. Before you sell, you could convert your primary residence to an investment property, so the loss would be deductible. Or you could leave the home vacant (using it as a vacation home while you pay the mortgage, into very attractive financially) so that if it is no longer your primary residence for over 3 years of the last 5, you do not meet the “2 out of 5 most recent years” test.
The treatment of foreign currencies has other consequences.
If you have a CD in foreign currency and are rolling it over automatically, every time the CD matures you are deemed to have exchanged the foreign currency for dollars and back into foreign currency, generating a gain or loss.
Paying for a stock with Euro? You are considered to have sold that amount of Euro from your savings or demand account. Now what is the basis of those Euro? Well, some came from salary and interest received at different times, etc. Good luck.
Yep. There is a lot wrong with the U.S. tax system. A new IBS in Europe would be good.
The above example is plain wrong. The US has no right to tax abroad in this matter, particular when there’s no capital gain in Euro terms. Someone needs to contact ‘US persons’ across the EU and start raising money similar to the IBS effort in Canada. When I see an American born person on EU TV I take note of their name and put it down on a list for later use if such a campaign gets launched. All these people are EU citizens, from the assistant head of the British Museum, a UK radio DJ, a well known lady in Germany running her own cosmetics company, Bernie Sanders’s brother running as a Green MP in the UK, the former Mayor of Cambridge, England, or an Irish Senator. I’m sure there are many more examples. If they haven’t already renounced, are they going to be happy paying $2350 fee to the US Government and send off some 5 years of tax returns? Or paying an exit tax because they own a appreciated house in Central London? The FATCA clock needs to be turned back for resident citizens in those countries.