How fluctuating FX rates generate capital gains taxes on the discharge of debt and the sale of property – US citizens abroad!

FX rates and capital gains

Financial planning is difficult for US citizens abroad. I have been writing a series of posts that describe the tax treatment of US citizens abroad in very specific circumstances. Few would imagine many of these circumstances. I have recently written about when US citizens abroad sell a principal residence and why US citizens abroad  should not invest in TFSAs. I have written about why PFICs  must be avoided.

My topic today is how the fluctuating exchange rates can create “phantom gains”.  AARO  has noted and proposed the following as part of legislative tax reform for US citizens abroad:

Situation Today:
Based on current tax law, for Americans living abroad, currency fluctuations create U.S. dollar capital gains or losses even on daily transactions as well as on movements of short and long term investments done in local currencies.  The exchange rate on the purchase date and the exchange rate on the sale date determine the capital gain for the U.S. Treasury.

Proposal:
Allow Bona fide foreign residents the option to choose a foreign currency as their functional currency and calculate all capital gains/ loss transactions in that currency before converting to U.S. dollars.  The current average annual exchange rate with the U.S. dollar is then used to convert any gains/ losses into dollar amounts from the foreign currency.  Since the use of a functional currency is allowed for foreign subsidiaries of U.S. corporations, it is only reasonable that a similar logic be applied to U.S. citizens abroad.

Obviously fluctuating FX rates are a problem for US citizens abroad. My inspiration for this post comes from the following comment by Lisa on the Isaac Brock Society site. Anybody who has taken out a mortgage loan will have to deal with this problem.

@renounce mentions that “home ownership can be very taxing”. When I followed the link, I realized that what is described is not the whole picture.  US Persons abroad are penalized in many ways.  Not only is the capital gain on the sales price of the house taxed based on the value of the dollar when the house is bought and the value of the dollar when the house is sold, but the FX gain on the mortgage value also appears to be taxed. FX losses are not deductible. So it appears that unless you pay off your mortgage, you will could also face a tax on the payoff of the mortgage if your local currency is not valued the same as it was when you bought the house.

Lisa reminds us that there are usually two aspects to a real estate transaction. The first is purchase/sale of the property and the second is the borrowing/repaying debt. Both aspects can generate phantom gains or losses.

It’s a matter of perspective. If you have a mortgage of $100,000 Canadian dollars and you repay $100,000 Canadian dollars, how can there be a gain? There is none from the Canadian perspective. What if you were to buy and sell the house for 100,000 British pounds. The UK would not see a gain or loss, but the US will. Why? The US sees the world only in US dollars. When you file your US tax return you are required to convert the currency of your country into US dollars at the prevailing exchange rate.

Let’s follow this through with two examples which illustrate how changes in the FX rate affect both the discharge of debt and the proceeds received from the sale of the property

Example 1: A falling US dollar

Will generate a capital loss on the discharge of debt

In 2001 the Canadian dollar was approximately 70 US cents. This means that a $100,000 Canadian mortgage taken out in 2001 would be equal to $70,000 US dollars.

In 2007 the Canadian dollar was worth one dollar. The US dollar had fallen in value relative to the Canadian dollar. In 2001 only 70 US cents were required to purchase one Canadian dollar. In 2007,  100 US cents are required to purchase one Canadian dollar. This means that a $100,000 Canadian mortgage paid back in 2007 would be $100,000 US dollars.

In this scenario, from a US perspective, since you borrowed $70,000 and you paid back $100,000 you have incurred a phantom loss of $30,000 US.

This is how the falling dollar affects the discharge of debt – i.e. a circumstance where you are the payer.

Will generate a capital gain on the proceeds from the sale of the property

What if instead of borrowing the $100,000 Cdn to purchase you a property you paid for the property in cash? The answer is that you would have a phantom capital gain on the sale. Why? Lets look at an example. We will assume the the same exchange rates with a 2001 purchase and a 2007 sale. Both the buying and selling prices are $100,000 Cdn. Under Canadian law there would be no gain.

What about under US law? The answer is different. There would be a $30,000 phantom gain.

Purchase price $70,000 and sale price $100,000. There would be a phantom gain of $30,000 which would be taxable.

US tax laws will NOT allow you to deduct the loss. But, US tax laws would require you to include the gain.

Example 2: A rising US dollar

Will generate a capital gain on the discharge of debt

Imagine that in 2001 1 British Pound was equal to 1 US dollar. A mortgage of 100,000 British pounds would be equal to 100,000 US dollars.

Imagine that in 2007, 1 British Pound was equal to 50 US cents. A mortgage of 100,000 British pounds would be equal to 50,000 US dollars.

In this case the US dollar his risen in value relative to the British pound. Whereas in 2001 it took a whole US dollar to purchase one British Pound, by 2007 it take only fifty US cents to purchase one British pound. This means that the US dollar had risen in value relative to the British pound.

In this scenario, from a US perspective,  if you borrowed 100,000 British pounds in 2001 and you paid back 100,000 British pounds ($50,000 USD) you would have:

Borrowed $100,000 and paid back only $50,000 giving you a phantom capital gain of $50,000 to pay tax on.

Will generate a capital loss on the proceeds from the sale of the property

What if instead of borrowing the 100,000 British pounds to purchase you a property you paid for the property in cash? The answer is that you would have a phantom capital loss on the sale. Why? Lets look at an example. We will assume the the same exchange rates with a 2001 purchase and a 2007 sale. Both the buying and selling prices are 100,000 British pounds. Under UK law there would be no gain.

You are buying the property for 100,000 British pounds in 2001. You are selling the property for 100,000 British pounds in 2007. From the UK perspective there is no gain. But, from the US perspective there is a loss. Here is why:

The 2001 purchase price was 100,000 US. The 2007 sale price was $50,000 US. Hence, there would be a phantom loss of $50,000 US. The rising US dollar generated a phantom loss of $50,000 US.

Can any losses be deducted from any gains?

There are two aspects to the “real estate transaction”. One would hope that any losses from one aspect of transaction would be subtracted from any gains from the other aspect. This would leave you with a “net gain” or “net loss” to deal with accordingly. To view the total transaction as a “net gain” or “net loss” would mitigate the unfairness of what is already a very unfair situation.

But, it is not to be. As usual Form Nation imposes maximum unfairness on U.S. persons abroad.

Bernard Schneider on page 26 in a recent article in the Virginia Law Review, referring to  Quijano v. United States, 93 F.3d 26 (1st Cir. 1996); Rev. Rul. 90-79, 1990-2  C.B. 187. notes that:

Put another way, the United  States taxes the depreciation of its own currency. In addition, gains  due to foreign exchange are treated as ordinary income, even if the underlying transaction generates capital gain or loss.

For example, a taxpayer values an asset and determines its basis  in U.S. dollar terms on the date of the asset’s acquisition. Expenses  that are added to basis are converted into U.S. dollars at the exchange  rate on the date paid. When the asset is sold, the gain is calculated on  the date of disposition. By this mechanism, it is possible to have a real  loss in the foreign currency that appears as a (phantom) gain in U.S.  dollar terms and is taxed accordingly in the United States. The  absurdity of this situation is compounded to the extent there is a loan  in a foreign currency that has appreciated over the course of the term  of the loan. The loss in U.S. dollar terms on the loan cannot be offset  against a gain, if any, on the sale of the underlying asset.

Conclusion: The nature of the transaction is the key when determining whether there is a gain or loss. Assuming a falling US dollar, there will be a phantom gain on the sale of the property where you are receiving money, but a phantom loss on the discharge of the mortgage where you are paying money. Assuming a rising US dollar, there will be a phantom loss on the sale of the property when receiving the money and a phantom gain on the discharge of the mortgage when you are paying the money.

US law does require you to pay tax on the “net” phantom capital gain but will not allow you a loss on the “net” phantom capital loss.

How do you like freedom now?

Note: All of these posts are of a general nature. They are not intended to and should not be understood to be financial, legal, tax advice (or any other kind of advice). They are to alert you to possible issues that need to be discussed with your adviser.