Phantom foreign currency gain on foreign property.

• Author: Swilling, John F.

Without realizing it, individuals can easily engage in a foreign currency transaction that can result in U.S. income tax. For example, under Secs. 985, 988 and 989, when an unsuspecting foreign individual purchases property abroad for personal use and sells it after becoming a U.S. resident, he may be subject to tax on gain. This arises from a fluctuation in currency exchange rates, even if the individual is not subject to gain in a foreign currency.

A taxable transaction of this sort falls under the provisions of subpart J (Secs. 985-989), which provide a comprehensive structure for the taxation of foreign currency and attempt to clarify the sometimes inappropriate or ambiguous tax implications instigated by transactions conducted in a foreign currency.

Sec. 985 describes a functional currency and provides the fundamental basis for foreign currency transactions. For example, the functional currency for a U.S. citizen or resident is the U.S. dollar. Sec. 986 discusses the translation of foreign income taxes for foreign tax credit purposes, and the translation of a foreign corporation's earnings and profits. Sec. 987 discusses the conditions of a U.S. branch operating with a jurisdictional functional currency other than the U.S. dollar. Sec. 988 covers the treatment of certain foreign currency transactions in nonfunctional currency and addresses the timing, character and source of foreign currency gains and losses in nonfunctional currency. Finally, Sec. 989 discusses miscellaneous issues.

The regulations under subpart J seem to reflect a transaction's true economic substance, but only when an individual whose functional currency is the U.S. dollar purchases an asset. However, for individuals whose national currency is not the U.S. dollar, the regulations appear to generate a "phantom" gain. Individuals in this situation may be able to structure the transaction prior to establishing U.S. residency, to eliminate or minimize the U.S. tax implications.

How It Works

A U.S. individual who purchases a vacation property for personal use in a foreign jurisdiction and subsequently disposes of it may be subject to a foreign currency gain or loss under subpart J.

Example 1: A U.S. citizen, N, who lives and works in the U.S., purchases a ski chalet in Switzerland for 300,000 Swiss francs (SF) when the exchange rate is 2 SF for every U.S. dollar. Two years later, N sells the chalet for 300,000 SF when the exchange rate on the date of the sale is 1.5 SF...