Tax Consequences of Foreign Currency Fluctuations

In 2015, the Brazilian Real declined against the U.S. dollar by more than 30%.  The currency fell sharply in the first trading session of the year, sinking as low as 4.06 to the dollar and recovering slightly to 4.04 to the dollar by afternoon.

Investors in foreign currency will need to take careful note of the rules in IRC § 988 which deals directly with the treatment of foreign currency transactions.  For U.S. tax purposes, viewed from the standpoint of the U.S. dollar, all foreign currency is personal property.  Therefore, sale or exchange of a foreign currency is a realization event which required the determination of a gain or loss.

When an individual holds a foreign currency which fluctuates, any appreciation or depreciation in value is an unrealized gain or loss, that is, a gain or loss that is only on paper.   It is the sale or exchange of the foreign currency that triggers the realization of the gain or loss.  In accordance with IRC § 988(a)(1)(A), the foreign currency gain or loss is taxed as ordinary income or loss.

IRC § 988(c)(1) deals with a defined group of transactions and prescribes certain timing, character and source consequences for “foreign currency gain or loss,” associated with those transactions.  These transactions include acquiring a debt instrument, forward contract, futures contract, option or similar financial instrument held in a non-functional currency.  Certain transactions such as a loss of at least $50,000 under a IRC § 988(c)(1) transaction can trigger special reporting requirements such as filing a Form 8886 Reportable Transaction Disclosure Statement.

IRC § 988 transactions can become extremely complex, therefore it’s advised that taxpayers with foreign currency transactions should exercise due care and seek the guidance of a qualified advisor.