Let's start with the TLDR example
My friend lives in Europe and earns wages in EUR. He is single and has no connection to the United States other than being a US citizen and former resident of the US. He bought a house in Europe in October 2020 for €460,000 EUR. For the sake of simplicity, let's assume that the loan with the bank was also €460,000 (which isn't too far off because many banks in Europe will 100% finance a primary residence). On that date in October 2020, the EUR->USD exchange rate was 1 EUR = 1.17238 USD. Which means that in the eyes of the US Internal Revenue Service (IRS) he bought a house for $539,294 USD with a mortgage of $539,294 USD. He got an interest rate on his mortgage of 1.65%.
Fast forward to October 2022 and he is moving back to the US to be near an ailing parent. He lists the house for sale, and due to rising rates in Europe he is offered €460,000 EUR by the potential buyer. If he accepts the offer, here is his European side of the transaction:
Proceeds from sale: €460,000
Mortgage payoff: (€435,900) (balance as of Oct 2022)
Local tax: €0 (exempt as Primary Residence)
US capital gains tax: €0 (sale is a loss on paper due to currency changes)
Cash left: €24,100 (=$23,427 on Oct 15 2022)
Here comes the big baseball bat to the head, foreign currency income under US IRC Sec. 988...
Original mortgage: $539,234 (exchange rate from Oct 2020)
Principal repayments: ($27,336) (exchange rates varied over two years)
Mortgage payoff: ($424,887) (exchange rate from Oct 2022)
Taxable income: $87,011 (ordinary income on his Form 1040 Schedule 1)
US ordinary tax: $27,844 (the income itself pushed him into the 32% tax bracket)
He owes $27,844 of US tax on the sale of a house that netted him $0 of profit (bought and sold for the exact same price, zero economic gain). And since he only has $23,427 of cash in his hands after paying off the mortgage, he has to come up with an additional $3,744 to pay the US tax bill. If this set of transactions had occurred in USD he would have paid $0 of tax and would have $23,427 of cash in his hands to invest for his future.
It is important to know that this can also happen if you refinance your mortgage! If you only roll an existing mortgage to a new property then it likely isn't an issue but check with your tax advisor. When re-financing your mortgage, you are paying off one mortgage and starting a new one. This is an even worse outcome because you have $0 in your hands to pay the tax (since you haven't sold the house) so you have to come up with $27,844 of cash.
Another example, with exchange rates going the other direction (a "less bad" outcome)
I made this one up to illustrate the problem when the exchange rates go the other direction. I also had to accentuate a (possibly real) scenario where there is an actual gain on the property.
Let's go back to June 2001. Imagine you bought an apartment in Amsterdam for €200,000 when mortgage rates were about 5%. On that date in June 2001, the EUR->USD exchange rate was 1 EUR = 0.8484 USD. Which means that in the eyes of the IRS, he bought a house for $169,680 USD with a mortgage of $169,680 USD.
Fast forward to June 2008 and he is moving back to the US. He lists the house for sale, and he accepts an offer of €350,000 EUR by the potential buyer. At this point, here is his European side of the transaction:
Proceeds from sale: €350,000
Mortgage payoff: (€175,890)
Local Tax: €0 (€150,000 gain exempt as Primary Residence)
Cash left: €174,110 (=$274,328 on June 1, 2008)
On the US IRC Sec. 988 foreign currency income/loss side...
Original mortgage: $169,680 (exchange rate from June 2001)
Principal repayments: ($29,497) (exchange rates varied over 7 years)
Mortgage payoff: ($277,132) (exchange rate from June 2008)
Foreign currency loss: ($136,949) (disallowed loss)
He repaid more debt than he agreed to (on paper in the eyes of the IRS), but only because of the exchange rates. He didn't actually pay more debt since he earns his wages in EUR.
HERE is where the baseball bat comes in on the capital gains tax side
Proceeds from sale: $551,460 (exchange rate from June 2008)
Original basis in house: ($169,680) (exchange rate from June 2001)
US capital gain: $381,780
Less exclusion: ($250,000) (amount exempt as Primary Residence)
Taxable gain: $131,780
Capital gains tax: $19,767 (assumed the 15% rate for simplicity)
You might naturally think that the foreign currency loss could be used to offset the taxable gain, but you would be wrong. That loss is an ordinary personal loss (not capital) so it cannot offset the capital gain on the sale of the house. In his local home, he had an economic gain of €150,000 EUR which is below the 250,000 exemption value for a single person. From an academic and policy perspective, and in my opinion, this economic gain should be entirely exempt from US capital gains tax. But here he is, owing $19,767 of tax. Now, you might scream at me "but he has $274,328 of cash to pay it!!". Yes, but he doesn't conduct his daily life in USD so he doesn't have USD in his bank account. After paying the $19,767 of US taxes, he has €161,565 left in his bank account. Still a very health amount of money to pocket for his FIRE future but only after throwing away tax on a gain that would have been fully exempt ($0 of tax) if it had fully happened in USD. I guess we can rest at night knowing in this case that he does have the cash to pay the extra tax.
How does this happen? For the nerds.
The US taxes its US citizens and US greencard holders (even if expired) on their worldwide income. Under Internal Revenue Code (IRC) Section 1.985-1, a US taxpayer's functional currency is USD (unless they run a business which we aren't discussing here). IRC Section 988 requires that foreign currency income/gains and losses be calculated where a transaction is executed in a currency outside of the taxpayer's functional currency. This means that the purchase and sale of non-US assets, and the issuance and repayment of non-US debts, can have currency rate fluctuation exposures if those purchases, sales, issuances, and repayments are not in USD (e.g. EUR in our example of my friend).
Why don't the house and debts offset eachother? Because the IRS sees the real estate transaction as completely separate from the mortgage transaction. They have no relationship to eachother in the personal circumstances of natural people (though different outcomes could occur for businesses). And personal losses can never be deducted (with some very small exceptions).
As recently as 2022, the US Treasury has proposed some rules to remedy this issue. However, as you can see on page 90 of the 2023 Greenbook, they only propose allowing the losses on the mortgage to be netted against a gain on the house. That seems to me to the lesser problem since you at least have cash to pay the tax when there is a gain. There is no mention of fixing the foreign currency gains/income.
Now what for my friend?
I am not a fan of being an alarmist, but, he is trapped with that house.
He could rent it out (if local laws allow it) and then move back to his European house when his parent is better. Some might say he could rent it out while he waits for the currency exchange rate to go back the other direction. But I have to say, currency exchange rates are not like the stock market which will experience turbulence but always goes up. Foreign currency isn't meant to do that and is controlled through government monetary policy. It can take a really long time to go back the other direction and you could then be sitting on a poor financial choice for other reasons (e.g. opportunity costs, market changes in the value of the house, etc).
Next time, he should talk to a tax advisor before buying real estate in case he can setup a business or other structure to buy the property instead. However, that comes with its own entire host of other tax problems and costs that might skew the outcomes in negative ways (and completely ignoring difficulties and costs in obtaining a mortgage that way).
Personally? I really hate that I have to deal with this and it makes the economic gains of owning real estate essentially nil (or even negative). Does it always play out this way? Of course note, but I've already got strong feelings about buy vs. rent and this risk just gives further weight to my position especially while living abroad. I'm not buying foreign property again unless I renounce my citizenship or unless the US fixes this problem.
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