Phantom Foreign Currency Gain on Foreign Property

Without realizing it, individuals can easily engage in a foreign currency transaction that can result in U.S. income tax. For example, under Secs. 985, 988 and 989, when an unsuspecting foreign individual purchases property abroad for personal use and sells it after becoming a U.S. resident, he may be subject to tax on gain. This arises from a fluctuation in currency exchange rates, even if the individual is not subject to gain in a foreign currency.

A taxable transaction of this sort falls under the provisions of subpart J (Secs. 985989), which provide a comprehensive structure for the taxation of foreign currency and attempt to clarify the sometimes inappropriate or ambiguous tax implications instigated by transactions conducted in a foreign currency.

Sec. 985 describes a functional currency and provides the fundamental basis for foreign currency transactions. For example, the functional currency for a U.S. citizen or resident is the U.S. dollar. Sec. 986 discusses the translation of foreign income taxes for foreign tax credit purposes, and the translation of a foreign corporation's earnings and profits. Sec. 987 discusses the conditions of a U.S. branch operating with a jurisdictional functional currency other than the U.S. dollar. Sec. 988 covers the treatment of certain foreign currency transactions in nonfunctional currency and addresses the timing, character and source of foreign currency gains and losses in nonfunctional currency. Finally, Sec. 989 discusses miscellaneous issues.

The regulations under subpart J seem to reflect a transaction's true economic substance, but only when an individual whose functional currency is the U.S. dollar purchases an asset. However, for individuals whose national currency is not the U.S. dollar, the regulations appear to generate a "phantom" gain. Individuals in this situation may be able to structure the transaction prior to establishing U.S. residency, to eliminate or minimize the U.S. tax implications.

How It Works

A U.S. individual who purchases a vacation property for personal use in a foreign jurisdiction and subsequently disposes of it may be subject to a foreign currency gain or loss under subpart J.

Example 1: A U.S. citizen, N, who lives and works in the U.S., purchases a ski chalet in Switzerland for 300,000 Swiss francs (SF) when the exchange rate is 2 SF for every U.S. dollar. Two years later, N sells the chalet for 300,000 SF when the exchange rate on the date of the sale is 1.5 SF for every U.S. dollar. As a result of the transactions, N has a $50,000 gain for U.S. tax purposes, related entirely to the change in the U.S.-Swiss-franc exchange rate.

N purchased and sold the chalet according to Sec. 985, meaning that he converted U.S. dollars into Swiss francs. As such, he had to determine the cost in dollars of the purchase and sales prices based on the prevailing exchange rates at the time of each transaction. Therein lies the application of Sec. 988, which applies only to transactions that involve the acquisition and disposition of nonfunctional currency.

Although the chalet's fair market value did not appreciate in the two years that N owned the chalet, the home increased in value in terms of the strength of the U.S. dollar. In Example 1, the Sec. 988 transactions include the purchase of SF with U.S. dollars, the disposition of the SF to buy the chalet and the disposition of the SF proceeds from the sale of the chalet by converting them into U.S. dollars. Any gain or loss on a Sec. 988 transaction is ordinary gain or loss (Sec. 988(a)(1)(A)). If the transactions are completed within a short period of time, any gain or loss would probably be minimal. Further, no Sec. 988 gain or loss in any transaction would be recognized if it is less than $200 and arises from a personal transaction (Sec. 988(e)(2) and (3)). Neither the acquisition nor the disposition of the chalet is a Sec. 988 transaction (Regs. Sec. 1.988-1(a)(6), Example 8).

However unpleasant taxable gain may be for U.S. individuals, at least it is understandable, as the transaction increases the individual's wealth in U.S. dollars. Unfortunately, gain from the same transaction may not be as forgiving of foreign individuals who evaluate the transaction in terms of their national currency.

Example 2: The facts are the same as in Example 1, except the taxpayer, H, is a Swiss citizen who has lived and worked in Switzerland his entire life. H sells the chalet shortly after moving to the U.S. on a temporary foreign assignment, while a U.S. resident. He has a taxable $50,000 capital gain, which arises solely because of the change in the foreign exchange rate.

The foreign translation rules applied to foreign individuals temporarily resident in the U.S. may produce taxable gains that do not represent the individual's "true" economic gain in foreign currency. The issue arises when the individual's functional currency is not the U.S. dollar at the time he purchases an asset and receives a basis. If the individual sells the asset while he a is resident in the U.S., he would have to convert the foreign currency basis to a U.S. dollar basis using the exchange rate on the date of purchase. This subjects the foreign individual to currency fluctuations for the entire time he owns the asset.

Case Law

The taxability of gain is supported by Quijano, 93 F3d 26 (1st Cir. 1996), aff'g DC ME (1995). In Quijano, the court held that to calculate a foreign currency gain or loss, an individual had to report the cost and selling price of his residence "at the rate of exchange prevailing as of the date of the purchase and the date of the sale, respectively." Further, the Code's provisions treat the transaction as if the individual had converted dollars into a nonfunctional currency to purchase the house, because the individual has to determine adjusted basis in the functional currency—the dollar.

From John F. Swilling, CPA, and Jones Lam, MST, Washington DC