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.
If you want to stop getting this thing every Friday, just click the “unsubscribe” link at the bottom of this email. I won’t be offended. On the other hand, if you want more, you can sign up for one of my other mailing lists.
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:
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.
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.
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.
There are two key concepts that you need to understand in order to have any hope of understanding tax logic.
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).
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.
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:
When you went to the French bank to get a mortgage, you are treated as if you borrowed US$1,400,000 (€1,000,000 x US$1.40/€1), then used those Dollars to buy €1,000,000.
You used those Euros to buy the house.
Your acquisition cost for the house — in U.S. Dollars — was $1,400,000. The math for getting that number is:
Your acquisition cost will be your “basis” (U.S. tax jargon alert!) for calculating your U.S. capital gain when you eventually sell the house.
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 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.
This means in dollar terms you are US$400,000 richer than you were when you started.
This US$400,000 gain is taxable. The IRS rulings and Tax Court cases are clear on this.
Isn’t that fun? You break even on the real estate deal but you have taxable income as far as the IRS is concerned.
See you next week. I have a kid graduating from high school (headed to UCLA in the fall) and another graduating from 8th grade and heading for high school. It will be a busy week.