This article is only relevant if you are a US taxpayer and you have a non-US Dollar denominated mortgage. For example, you are a US citizen living in London and you have a UK mortgage in Pound Sterling. If you are considering repaying this loan then you should be aware of foreign exchange gains (FX Gains), when these occur and the options available to you.
What is it? – In short, a foreign exchange gain arises when you repay a foreign currency loan at a lower USD figure, based on the change in exchange rate from the day you took out the loan to the date of repayment.
To put things into perspective, John borrowed £100,000 on Jan 2nd, 2014. He then repaid this loan in full on Jan 2nd, 2018. The calculation would look a little something like this:
|GBP||Bank of England Exchange Rate||USD|
|Borrowed on Jan 2014||£100,000||1.6437||$164,370|
|Paid off on Jan 2018||£100,000||1.3579||$135,790|
Although John has not realised a gain in the UK, he is a US taxpayer and must use USD as his functional currency. He is deemed to have repaid a lower amount in USD which has resulted in an FX gain of $28,580!
When does this occur? – You do not only have to physically repay the loan for an FX gain to occur. Any of the following events may result in a gain being realized:
- Refinancing; effectively paying off the original loan and taking out a new loan
- Capital Repayment; a lump sum payment outside of your regular monthly re-payments.
- Sale of property; any remaining mortgage being paid back to the lender –https://pjdtax.co.uk/updates/im-a-us-taxpayer-and-im-thinking-about-selling-real-property/
These events are not designed to benefit from the fluctuation in exchange rate, especially if you are living in a foreign country, but they will still be caught by these rules.
What is the tax rate? – This gain is subject to US income tax rates, which could be as much as 37%. Furthermore, Net Investment Income Tax (NIIT) is also applicable, increasing the tax by 3.8% if your adjusted gross income exceeds the NIIT threshold https://pjdtax.co.uk/updates/net-investment-income-tax/.
Any more bad news? – Unfortunately, yes:
- If you were to realise a foreign exchange loss, there is no facility to utilise or carry this forward on your US tax return
- This is an income gain and cannot be offset by other capital losses
- The gain is considered foreign passive (investment) income and therefore foreign tax credits built up in the general limitation category (employment income) cannot be used against it
Any good news? Not really, but here are a few options:
- If the mortgage is in joint names with your spouse who is a non-US individual and your filing status is married filing separately then you only need to report your half of the gain
- If your spouse is a non-US person, then it may be possible to restructure your ownership of the property and the mortgage to minimize your exposure to an income tax charge. There are gift tax considerations and we recommend speaking to us for more specific advice.
CAUTION! The fluctuation in exchange rates may also affect the realised gain or loss on any sale of non-US assets. For example, you sold some stock in a UK company. You must convert the purchase price to USD at the exchange rate on the date of purchase and convert the proceeds to USD on the date of sale. This can have a significant impact on the size of the gain. A GBP loss could result in a USD gain.