How Fluctuating Foreign Mortgage Exchange Rates Leads to U.S. Taxes

How Fluctuating Foreign Mortgage Exchange Rates Leads to U.S. Taxes

How Fluctuating Foreign Mortgage Exchange Rates Leads to U.S. Taxes

When it comes to international tax law, one of the most complex issues to be aware of are issues associated with exchange rates and how changes in currency or fluctuations in currency exchange values may inadvertently lead to U.S. tax liability. One common situation to consider is when a US person may have acquired a foreign property using a foreign mortgage. In this type of situation, the tax trap exists in the fact that if the exchange rate improves to the extent that it takes fewer U.S. dollars to purchase the foreign currency then the taxpayer may have an unforeseen U.S. tax liability due to a difference in exchange rates in the payment of a foreign mortgage. The reason this is common in foreign mortgages is because exchange rates tend to move the meter each year, and many mortgages may exist for 5/10/20 or 30 years– thus, resulting in these unwanted tax implications. Let’s take a brief look at how this may work.

26 U.S.C. Section 988 

      • “Treatment as ordinary income or loss

        • In general

          • Except as otherwise provided in this section, any foreign currency gain or loss attributable to a section 988 transaction shall be computed separately and treated as ordinary income or loss (as the case may be).”

Example of Foreign Mortgage Exchange Income

Sometimes tax law can be unnecessarily dense, so let’s work through a simple example to explain the concept.

      • Jennifer takes a $200,000 loan out in a foreign country to pay her mortgage. Because of the exchange rate, the value of Jennifer’s mortgage in the U.S. is $250,000.

      • That is because the foreign country has a stronger currency than the United States so that it costs more than a dollar for Jennifer to buy $1.00 worth of currency in the foreign country.

      • Fast forward five years later and Jennifer pays off her mortgage. At this time, It only cost Jennifer $210,000 to pay off the mortgage. That is because the US currency became stronger relative to the foreign country’s currency.

      • In other words, where before $1.00 from the United states would only purchase $0.80 in the foreign country, now that same $1.00 of USD would buy her $0.95 in the foreign country so that she had to use less U.S. dollars to by the foreign currency sufficient to pay off the loan (understanding mortgages don’t exactly work like that, but the idea is simply it cost Jennifer less money to pay off her foreign mortgage).

      • As a result of this transaction, Jennifer saved $40,000 because she had to spend less money in USD to pay off the foreign currency mortgage (which she paid off using the foreign country’s functional currency).

Why Foreign Mortgage Payoff Leads to U.S. Taxes?

There are two reasons the foreign mortgage payoff leads to U.S. tax implications. First, the United States does not consider foreign currency to be currency, but rather they consider it to be property. Second, just looking at the numbers, if Jennifer had paid off the mortgage in the same year she acquired the mortgage, it would have cost her $250,000 to buy the $200,000 necessary to pay off the mortgage.  Here, it only costs Jennifer $210,000 so she essentially made $40,000, which is taxed as Ordinary Income (OI).

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