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Barron's International Tax Service

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Taxable Gains From Foreign Currency Conversions

Have you wondered about how the Internal Revenue Service looks at currency gains between the euro and the dollar?  For instance suppose in 2001 you brought $100,000 from your American portfolio account to invest in the European market when the dollar was on par with the euro, or $100,000 could buy €100,000; the exchange rate being 1.0000.  Suppose further that you sold your investment in 2005 for €90,000.

Stateside IRS allows capital losses to offset capital gains.  So if you happened to have had capital gains equivalent to the European loss of €10,000 x exchange rate, you can absorb the entire loss.  Otherwise IRS will limit the loss to $3,000 for married couples and $1,500 for singles.  The balance gets carried forward.  Whichever amount you can apply - $3,000 or $1,500 - goes to offset other taxable ordinary income.

However you also experienced a gain in foreign currency.  The euro ended up at 1.2437 as an average for the year.  Of course if you had several sales in 2005, you could be more precise and use the exchange rate on date of each sale.  But IRS hasn't been so precise in checking.  So €90,000 is worth $111,933 (€90,000 x 1.2437).  This means you had a currency gain of $11,933 ($111,933 - $100,000) that should be reported for taxation at ordinary income tax rates. Hardly seems fair.  But according to IRS in Paris, the Service wants to tax currency gains resulting from investments, trade or business.

What about your personal residence?  For many Americans abroad, their main investment is in their home.  And the value of that investment has been increasing substantially.  Suppose you bought your home in 2001 for $100,000 (€100,000).  In 2005 you sell for €500,000 because you want to move to Florida.  You will of course have to pay the foreign tax man the tax applied to the €400,000 gain on sale less whatever adjustments are allowed.

In 1997 the new tax legislation stateside allowed Americans a lifetime exclusion on gains from sales of personal residence up to $500,000 for married couples and $250,000 for singles.  Supposing you are married, would your entire gain be excluded: $497,480 (€400,000 x 1.2437)?  Or would you have to pay taxes against the foreign currency fluctuation of $97,480, with only the balance of $400,000 (€400,000 x 1.0000) being allowed under the lifetime exclusion rule?  Remember that in 2001 the dollar was on par with the euro.  And so the purchase price in this example was $100,000/€100,000.  Now in 2005 the relationship is 497,480/€400,000.

The answer to this question is the gain from sale of personal residence is not included in the ordinary taxation effects of any gains from changes in foreign currency.  The seller/taxpayer simply includes the foreign currency gain as part of the overall gain from sale of his or her home.  As this example demonstrates, a foreign currency gain has the disadvantage of eroding the lifetime exclusion.  But what the heck.  You made off like a bandit on the house sale and with a favorable exchange rate will have a bundle to invest in Florida (less what the tax man might ask about that original $100,000).