Are all foreign currency gains taxable?
No. Under a de minimis exemption individual taxpayers with foreign currency gains of $200 or less on a “personal transaction” do not need to report them.
How does the $200 de minimis exception apply to individuals?
The $200 de minimis exception applies on a transaction-by-transaction basis. Assume, for example, that an individual buys a piece of jewelry for 300 pounds sterling in a personal transaction. Assume, further, that the taxpayer pays for it with pounds sterling that have appreciated in value. If the appreciation upon the payment for the jewelry is U.S. $200 or less, the taxpayer does not need to report the gain on their tax return. If gain on the British Pounds used to purchase the jewelry exceeds $200, however, all of the gain on that transaction is taxable: the de minimis exception does not apply, so the taxpayer cannot avoid tax on any of the gain.[1]
Which transactions are defined as “personal transactions”?
A transaction is a “personal transaction” when an individual enters into it for personal reasons.[2] Related expenses cannot be deducted as trade or business expenses,[3] or as expenses incurred in the production of income.[4] Personal transactions generate nondeductible losses because they are not incurred in a trade or business or from an activity engaged in with the intent of generating profit.[5] Personal expenses are defined for these purposes to include expenses incurred by an individual in connection with business travel.[6] Foreign currency that a U.S. person purchases to fund personal transactions on a vacation is not subject to Code § 988.[7]
Do personal transaction rules apply to a personal residence purchased in foreign currency?
Yes. If none of a taxpayer’s expenses incurred with respect to a personal residence purchased in a foreign currency are deductible as trade or business expenses or as expenses incurred in the production of income,[8] section 988 does not apply. This means that the taxpayer will have capital gain on the personal residence, while any losses are not deductible.[9] If the taxpayer takes out a foreign residential mortgage, the IRS treats their foreign residential mortgage and the foreign residence on which it is collateralized as two separate, independent personal transactions. Such a taxpayer can face a “tax whipsaw,” where gains are taxable, but losses are not deductible. Section 988 only applies to business mortgage loan financing.[10]
How are foreign currency losses reported?
Foreign currency losses are treated as ordinary, so they should not be subject to any of the tax rules that apply to losses on capital assets. Treasury Regulations confirm this point, stating that “unless a valid election is made under [Code section 988(b)], any section providing special rules for capital gain or loss treatment, such as sections 1233, 1234, 1234A, 1236, and 1256(f)(3), shall not apply.”[11]
Section 988 losses are treated as ordinary for all purposes. Taxpayers receive a deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.”[12] In determining the amount of the loss allowed, the taxpayer’s tax basis is its adjusted tax basis.[13] A taxpayer is allowed a deduction for a loss sustained during the taxable year if it is uncompensated.[14]
Are foreign currency losses treated as “reportable transactions”?
Yes, when the foreign currency losses exceed certain threshold amounts for individuals and corporate taxpayers. Certain foreign currency losses are treated as reportable transactions on the taxpayer’s tax return. Losses that are treated as reportable transactions must be included in a disclosure statement filed with the taxpayer’s tax return.[15] Section 988 losses of at least $50,000 in a single year are reportable transactions for an individual or trust taxpayer.[16] Reporting is required regardless of whether losses flow through to the taxpayer from an S corporation or a partnership.[17] Section 988 losses of at least $10 million in any single taxable year (or $20 million in any combination of taxable years) are reportable transactions for a corporate taxpayer.[18]
Can a taxpayer elect to receive capital gain or loss on a foreign currency transaction?
Yes. A taxpayer can choose to treat foreign currency gains or losses attributable to certain forward contracts, futures, and options as capital.[19] To qualify for this election out of section 988, the foreign currency contract must be a capital asset in the taxpayer’s hands; in addition, the transaction must be properly identified before the close of the day on which it is entered into.[20] If such a contract is (or becomes) part of a tax straddle, gains on the transaction are treated as ordinary, while losses remain capital unless the IRS invalidates the election.
Which tax timing rules apply to foreign currency transactions?
Various Code provisions can affect the time a taxpayer reports gains and losses. For example, the section 1092 straddle rules and the section 1256 rules that apply to “section 1256 contracts” take precedence over section 988 treatment.[21] This means that if a taxpayer elects into section 988 for its regulated futures contracts (RFCs) and “non-equity options,” those 1256 contracts are marked-to-market at year end under the rules at section 1256, but they are marked at ordinary rates under section 988.[22] In addition, forward contracts that qualify as section 1256 contracts (as foreign currency contracts) and that are also subject to section 988 treatment are marked-to-market at year-end at ordinary rates.
[1] Code § 988(e)(2)
[2] Code § 988(e)(3).
[3] Code § 162.
[4] Code § 212. Whether expenses are attributable to the production of income is determined without regard to the rule limiting certain miscellaneous itemized deductions to the amount in excess of two percent of a taxpayer’s adjusted gross income. Code § 67(a).
[5] Treas. Reg. § 1.165-1(e) (1977). See also Rev. Rul. 90-79, 1990-2 C.B. 187 (Jan. 1. 1990).
[6] Code § 162(a)(2).
[7] Treas. Reg. § 1.988-1(a)(9)(ii), Example (2).
[8] Rev. Rul. 90-79.
[9] Id.
[10] Carlos J. Quijano and Jean M. Quijano, Appellants, v. United States of America 93 F.3d 26 (1st Cir. 1996). In this case the taxpayers had conceded that their mortgage transaction was not entered into for profit.
[11] Treas. Reg. § 1.988-3(a).
[12] Code § 165(a).
[13] Code § 1011.
[14] Treas. Reg. § 1.165-1(a). Code § 165 limits certain types of losses.
[15] Treas. Reg. § 1.6011-4(a)
[16] A Code § 165 loss includes an amount deductible pursuant to a provision that treats a transaction as a sale or other disposition, or otherwise results in a deduction under Code § 165, which includes a loss resulting from a section 988 transaction. Treas. Reg. § 1.6011-4(b)(5)(iii)(B)
[17] Treas. Reg. § 1.6011-4 (b)(5)(E)
[18] Treas. Reg. § 1.6011-4 (b)(5)(A). In determining the $20 million threshold, losses from one transaction claimed in the year the transaction is first entered into are combined with losses from the same transaction in the succeeding five years.
[19] Code § 988(a)(1)(B)
[20] Id.
[21] Treas. Reg. § 1.988-2(d)(2)(i).
[22] Section 1092 straddle rules might apply to deferred losses with respect to section 988 transactions unless another Code section controls, such as 1001 or 1256.
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