How is the Sale of a Foreign Personal Residence Taxed in the US?

One of the most common issues I see (and probably the one with the most impact) is the taxation on the sale of a foreign personal residence. 

US citizens (and greencard holders) are required to use the US Dollar as their "functional currency" for all "personal" transactions, including the purchase and sale of a foreign residence.  For most US expats, there are actually two separate taxable transactions that occur when you sell a foreign residence - "Capital Gain" from selling the residence, and "Exchange Rate Gain" from paying off a mortgage denominated in a foreign currency.

Taxation of Capital Gain:

The current tax rate on the gain from selling a personal residence is 15% (as long as you have held the property for at least a year).  The gain is calculated by translating the purchase price using the exchange rate at the time of the purchase, the cost of capital improvements using the exchange rate at the time the improvements were made and the exchange rate at the time of the sale, rather than by using the exchange rates at the time of sale in all three cases (C.J. Quijano v. US; 96-2 USTC P 50,441).  If you meet the requirements of IRC Sec. 121 (you owned and used the property for 2 of the 5 years prior to the sale or meet one of the exceptions), you are allowed to use the $250,000 ($500,000 if MFJ) exclusion available to properties located in the US.  If the result is a capital loss, this is considered a personal, non-deductible loss.

Taxation of Exchange Rate Gain:

The Exchange Rate Gain from paying off a mortgage denominated in a foreign currency is treated a separate transaction and is calculated by translating the amount of the loan using the exchange rate at the time the loan was originated and the exchange rate at the time of the loan was paid off.  The resulting "gain" is taxable as "ordinary income" using your marginal tax rate (maximum 35% for 2008).  Again, if the result is a capital loss, this is considered a personal, non-deductible loss.

Note that you cannot use the loss from the mortgage payoff (which is what most people have these days) to offset the capital gain from the sale of the home (Revenue Ruling 90-79, 1990-2 CB 187).

These rules may look harmless enough, but the results can be devastating and should be taken into account if you are considering selling (or before buying) a foreign residence. 

David Colvin is a CPA and CFP® based in Amsterdam, Netherlands since 1998.  His niche focus is serving high-net-wealth individuals with cross-border tax and financial issues.  He is also an advisor to Maxim Global Wealth Advisors, based in Amsterdam and Portland, Oregon.

Comments

[Dave]

I am a US citizen and have lived abroad for over 15 years. I bought a house 6 years ago in a European country with the local currency that I have saved for years before that. I have zero current intention of returning to the US nor converting my local saved and invested currency ever back to USD after a sale as I will likely retire in this Euro-country permanently. How can my functional currency be USD?? It is totally artificial and unfair!!! Where is the "fact" in this situation vs. the "phantom" exchange rate effects on the house gain sale and mortgage element?? This makes no sense. The example also does not address the $250k/$500k exclusion on the gain, which I assume is applied to the house gain. BTW - interesting article, even though your conclusions are potentially scary. Any tax planning strategies in light of these situations?

[Taxpat BV]

Definitely an unfair law which is hurting a lot of my clients this year. One benefit is that you can use the $250/$500K exclusion. If you are over this amount there may be some planning ideas, a bit complex for this format.

[Summer2221]

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