by Craig Pellet, EA
For US tax purposes, only American currency counts as “money”. The currency of other countries – and non-state currency like Bitcoin – is considered “property”. Exchange rates between currencies change all the time. If the value of your foreign currency changes in dollar terms from when you acquire it to when you dispose of it, you will have a gain or loss that can be taxable. Generally, gain on appreciated currency is taxable at ordinary income rates – not as capital gain. Losses are frequently deductible at ordinary rates, too, which can be a boon where a foreign currency position has lost value. Indeed, at John Schachter + Associates we have repeatedly help clients spot such unrealized losses and profit from them. In most cases, the appreciation or deprecation is taxable when you dispose of (spend or convert) the foreign currency. This applies even if you purchase another foreign currency instead of spending or converting to dollars. Here are four scenarios:
The “vacation” exception
This exception is a good starting point, since it applies to many people. If you hold a foreign currency for personal purposes and you incur a loss of any amount, or your gain is less than $200, there is no tax due on the gain or deduction for the loss.
For example, you take a summer vacation to Pitlochry, Scotland. You exchange 1,000 US dollars for 650 British pounds. On the first day of your vacation, voters in the UK vote to leave the European Union, and the value of the pound plummets.Now your 1,000 dollars would have gotten you 850 pounds. Over the next week you spend your 650 pounds, and because the currency is worth less when you spend it than when you bought it, you have a loss. However, you can’t deduct it. You held your pounds for personal purposes, so your loss is not deductible.
The inverse case is true as well, to a point. Consider the same facts as above, but imagine that UK voters decided to remain in the European Union, and the British pound rose. Now your 1,000 dollars would have gotten you only 450 pounds on the second day of your vacation. You go to the pub and spend 100 pounds on dinner that night. Taxable gain, right? No. The $200 exclusion applies on a transaction-by-transaction basis. So as long as you don’t have a gain of $200 in a single transaction for personal purposes, your currency gain is exempt from tax.
Say instead you bought a fancy Highland sweater, and spend all 650 pounds in a single transaction. Your currency gain is more than $200. Even though this is a personal (non-investment, non-business) transaction, you must include the gain on your return and pay tax on that amount.
If you live abroad, the “vacation” exception still applies. Generally you don’t need to worry about currency gains unless you make big transfers to US dollars, or from one foreign currency to another.
However, keep in mind that big expenditures can trigger taxable events, especially if you hold significant amounts of cash in your spending account. If the turnover in your account is fast, then you shouldn’t need to worry too much about this, unless there are big shifts in the value of your currency against the US dollar. In other words, if you keep only 2-3 months of expenses in your spending account, as opposed to a year or two, the currency doesn’t have much time to appreciate, so you won’t have much gain, and are likely to remain under the $200 “vacation” exception.
Holding cash (whether living abroad or not)
Regardless of where you live, keeping savings in a currency other than the US dollar can expose you to taxable gains or losses when the currency is converted to US dollars. For example, you receive 10,000 Euros when those Euros are worth 12,000 US dollars. A few years later, you need the funds in US dollars, so you convert your 10,000 Euros and get 11,000 US dollars. Because the Euros were worth $1,000 more when you received them, you have a $1,000 taxable loss, at ordinary income tax rates. Had the Euros increased in value, you would owe tax on $1,000, also at ordinary tax rates.
Because your savings account qualifies as an investment, the “vacation” exception generally doesn’t apply, and the loss is deductible.
Holding foreign currency in an investment portfolio also can generate taxable gains and losses. Losses are fully deductible from ordinary income, without limits, and gains are taxable at ordinary income rates.Partnerships, S corporations and trusts that invest in foreign currencies can pass through this type of income or loss to owners and beneficiaries.
Bonds denominated in a foreign currency will also create currency gains and losses. In this case, the currency gain or loss is called out on your tax return separately from the market gain or loss upon sale or redemption of the bond. So, if the value of the bond principal has fluctuated against the US dollar, currency gain or loss will be recognized separately from gains or losses from movements in the market.
Contact us at JS+A to learn more about how currency gains and losses can affect your tax returns, how to plan for them, and how to take advantage of them.