Which Foreign Income Exchange Rate does IRS Require?
Which Foreign Income Exchange Rate for Tax Returns, FBAR & 8938: As if preparing tax returns involving foreign income, assets, accounts, or investments is not hard enough — the IRS does not make it much easier when it comes to deciphering foreign exchange rate rules. The main reason for the confusion is because there is not one specific exchange or official exchange rate you have to use (although you should always try to stick to an official rate). Essentially, as long as you are using a reasonable and appropriate exchange rate — you will be fine. It can get a bit confusing in matters involving a multi-year submission such as in an offshore disclosure, when taxpayers must refer to prior year exchange rates when filing past tax year returns — but don’t let it overwhelm you. Let’s walk through an example of Foreign Exchange Rates for Tax Returns, FBAR & Form 8938.
Marion’s Tax Return, FBAR, and Form 8938
Marion is getting ready to file his current year tax return. He is originally from Spain and still has some foreign accounts, specified assets, and income from overseas that must be reported on his US tax return. As he sits down to prepare his tax returns, he starts his Google research and finds the following excerpt on the IRS website:
- “You must express the amounts you report on your U.S. tax return in U.S. dollars. Therefore, you must translate foreign currency into U.S. dollars if you receive income or pay expenses in a foreign currency…”
Not the Most Helpful Guidance
The IRS does not have an official exchange rate that Taxpayers are required to use on their tax return. As further provided by the IRS:
- “…[I]t accepts any posted exchange rate that is used consistently.”
So in this particular situation, which exchange rate should Marion use?
Department of Treasury vs IRS Average Exchange Rates
The two most commonly used exchange rates are the IRS Average Annual Exchange Rate and the Treasury Department Exchange Rates — the latter is published quarterly.
When a Form 8938 is Required and Working Backwards
The Form 8938 is used to report Specified Foreign Financial Assets. The form is part of your tax return and included with most commercial tax software such as TurboTax or TaxAct. When it comes to exchange rates on Form 8938, there is a subsection under each asset that provides the following statement:
- “Source of exchange rate used if not from U.S. Treasury Department’s Bureau of the Fiscal Service”
Practice Pointer: You don’t want to make it any more difficult for the IRS examiner than it needs to be. Based on the IRS wording here, basically they are saying “Hey, use the U.S. Treasury Department’s exchange rate and if you use anything different from that, then let us know.” Some people simply prefer the IRS average exchange rate and that’s fine — others may journey into unofficial territory, which is unnecessarily dangerous and risky to the client — but you really can’t go wrong using the Treasury Department exchange rates.
Which Quarter to Use?
The Treasury Department rates are published each quarter, but most practitioners refer to the December 31st value (or Quarter 4) for reporting. Some practitioners prefer to use the exchange rate that is closest to the maximum account balance. I recall once our firm took over an audit for another law firm that did exactly that. Each year, they had different exchange rates for the different quarters based on when the maximum value of the account was for each asset. When talking with the experienced IRS Agent on the case, I recall him asking me “Why on earth would someone do it that way instead of just using the year-end exchange rate and keeping it consistent??” He then asked if it was okay for him to go back and use the year-end Department of Treasury Exchange Rate Value for each asset — and it resulted in nearly the exact outcome without the headache.
FBAR and Tax Return Exchange Rates
When it comes to the FBAR, most practitioners will also use the Department of Treasury — especially if a Form 8938 is included in the submission. That is because if the taxpayer is audited, it is best for the 8938 to match the FBAR — give or take $1 to reflect the rounding rule disparity between the FBAR and 8938.
According to the IRS, you can essentially use any exchange rate that is acceptable. So, in situations where a person has both a foreign income and foreign reporting requirement, the U.S. Treasury Department’s Bureau of the Fiscal Service is generally beneficial to use the same exchange rate — in order to keep it consistent — absent spot rates.
Spot Rate for Foreign Income
A spot rate exchange rate is used to reflect a specific exchange rate on a specific date(s). For example, if a person has a capital gain, then they will have a spot rate on the day they purchased or acquired the asset and a different spot rate on the day they sold or relinquished the asset. The IRS does not provide spot rates, so the most common spot rate source and the path of least resistance is OANDA. If the spot rate you need goes back further then OANDA provides for, then try to find the best spot rate you can and make sure to make a note of the source – and try to find the most official source that you can. In conclusion, it is important to use reasonable exchange rates when it comes to translating foreign income into US currency. The Internal Revenue Service does not provide one standard specific rate you have to use but oftentimes taxpayers will rely on either the the Treasury of Department exchange rates or the IRS average exchange rate. If a spot rate is required, you have to consider other sources (such as OANDA) to obtain those specific spot rates. The most important goal is to keep it consistent and easy for the IRS.
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