People constantly move, the world is becoming flat as Thomas L. Friedman is predicting for years already (by the way, if you did not read his last book, “Thank You for Being Late”, you should, I highly recommend it). Moving to a new place is exciting, learning about the tax rules is not.
As many of you know, U.S. is one of the two countries that tax its taxpayers on worldwide income (the other country is Eritrea… it’s a tiny northeast African country on the Red Sea coast). Thus, when a foreign person arrives to the U.S. and becomes a U.S. taxpayer either by meeting the substantial presence test rules under Internal Revenue Code (IRC) Section 7701(b), or acquiring a green card, he or she must report income earned inside and outside of the U.S. Usually it’s a non-U.S. source interest, dividends and rental income that is being reported by the newly arrived person. And one day this foreign person decides to sell a former residence located outside of the U.S. He heard that gains on the former personal residence can be excluded if he sells it within a certain time period. He could even have confirmed this IRC Section 121 exclusion with his tax preparer. Thus he sells the property and ends up paying no tax on the gain (assuming gain was less than $250,000 (single taxpayers) and $500,000 (married filing joint taxpayers). He then happily pays off the mortgage in the foreign country. And that very second, he creates a potential tax problem.
IRC Section 988 applies to a defined group of transactions and determines timing, character and source consequences with respect to “foreign currency gain or loss” associated with those transactions. Under the current IRS tax rules, the gain or loss on the sale of an asset denominated in a foreign currency must be computed using the U.S. exchange rates on the historical date for the acquisition cost and the exchange rate on the date of sale to determine the proceeds. As a result, in addition to a gain or loss on the asset sale, there will be this additional phantom currency exchange gain or loss.
When the taxpayer repays foreign mortgage denominated in a non-USD currency, the taxpayer is deemed to have another transaction where he needs to calculate foreign exchange gain or loss on the mortgage repayment. U.S. taxpayers generally use USD as their currency, thus transactions in foreign currencies need to be translated to U.S. dollars. Mortgage repayment in foreign currency will be translated to USD at the repayment date exchange rate.
This is a classic Quijano tax case transaction (Quijano v. United States, No. 96-1053). In Quijano, U.S. taxpayers lived and worked in London. They sold their London home and ended up paying tax not only on the sale gain but also on foreign currency exchange gain. This happened in the year before primary residence exclusion for gains. Quijano tried to convince both the IRS and later, the Tax Court, that he paid almost $30,000 in tax on a gain that he never realized (remember, he lived and worked in U.K.) and failed.
Quijano had a mortgage that was repaid after the residence was sold. The value of the dollar against the pound sterling declined from the time of the mortgage loan to the date of its repayment. If converted to US dollars, the taxpayers had a loss on the mortgage repayment:
At the mortgage acquisition date: mortgage amount GBP 330,180, exchange rate of $ 1.52, equals USD 500,327
At the mortgage repayment date: mortgage amount GBP 330,180, exchange rate of $1.82, equals USD 600,928
As you can see, it “cost” the taxpayers an additional $100,601 to repay mortgage denominated in GBP.
In Quijano, the taxpayers wanted to offset $100,601 currency exchange loss on the repayment against the gain incurred when they sold their London house. Government agreed that taxpayers sustained a loss on the mortgage repayment transaction. However, since property sale and mortgage repayment are two different transactions, taxpayers were not allowed to net two separate transactions into one. In addition, since the mortgage-loan transaction loss was for the personal property, mortgage loan transaction was neither carried out by a trade or business, nor entered into for profit, and as such was personal nondeductible loss.
Foreign mortgage repayment treatment as a disposition of a foreign financial instrument can cause unwelcome results for a lot of foreigners who arrive to the U.S. and U.S. citizens or green card holders who move outside of the U.S. and continue to be taxed on the worldwide income.
Always consult your tax preparer before you sell the property in the foreign country.
Should you have any questions or comments regarding foreign mortgage repayment, please contact me at info@jurategulbinascpa.com
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