This is a repost with some changes and more research resources to clarify the earlier article.
It may be hard to believe, but losing your foreign home to foreclosure can result in US tax consequences. The tax problems are worsened for the American abroad. Today’s post explains why. The topic is becoming more relevant to many Americans abroad who live in their own home in their foreign country of residence. Economic havoc from the coronavirus has found many Americans losing their overseas jobs and facing the terrifying prospect of losing their homes to foreclosure proceedings. The so-called CARES Act was enacted to bring economic relief to Americans suffering financially in the pandemic. In part, it sought to keep millions of Americans in their homes, but forgot that Americans overseas also are in dire need of help.
American Abroad Hit Harder than Stateside Counterpart
As a broad overview the CARES Act gave borrowers with federally backed mortgages the ability to request a pause in payments for up to 180 days if the borrowers were struggling under financial hardship. It was also possible for those borrowers to request another 180 days of relief. The law further barred lenders and servicers from foreclosing on borrowers with federally backed mortgages, as well as those backed by government-sponsored entities Fannie Mae and Freddie Mac. None of this relief is available to the US person living abroad whose home is mortgaged with a foreign financial institution. Relief from foreclosure lies solely within the discretion of the lender (unless, of course, the foreign country itself has enacted pandemic relief laws temporarily prohibiting such foreclosure actions).
Americans abroad are at a great threat of foreclosure actions on their overseas homes since they do not have the moratorium protections of the CARES Act. In addition, there are US tax complications with the forced sale of a home and these tax complications are, not surprisingly, greater for the US person abroad. It is often the case that the lending institution will agree to forgive a portion of the debt rather than pursuing other remedies to recoup the shortfall from the debtor. Generally, if a taxpayer is in default with a creditor and the parties reach an agreement such that the taxpayer can resolve the debt for less money than was originally owed, the amount that is “forgiven” is treated as “income” from the cancellation of indebtedness under the US tax laws.
Personal Residence
The rules are a little different when debt is forgiven with respect to a loan for one’s personal home. If the foreclosed home is the principal residence, a special tax break exists: “qualified principal residence indebtedness exclusion”. This exclusion may allow a taxpayer to exclude up to US$2 million (if married) of the forgiven debt. This tax break is a temporary provision, however, and it is one that must be renewed by Congress. Congress revived this so-called “tax extender” at the end of 2019, and currently the exclusion provision applies to debt discharges occurring before January 1, 2021. Another extension is needed, but we do not know what the future holds. If the provision is not extended and real estate values have plummeted (as they have in many areas) foreclosures will cause big problems for borrowers who will be faced not only with losing the home, but tax consequences in addition. Paying tax on phantom income, especially at this time, will really add insult to injury.
American Abroad and the Foreign Mortgage – A Sneaky Surprise with Foreign Currency Transactions
Sadly for the American abroad there will be a further tax problem – that involving foreign currency gains and losses. As readers of my blog know, foreign investments often result in significant US tax complexity. Transactions in foreign currency are often overlooked, but any taxpayer engaged in transactions involving foreign currencies (including mortgage loans denominated in a currency other than the US dollar) should be prepared for significant tax reporting burdens. In the case of debt forgiveness on foreclosure actions, the tax laws can result in a harsh surprise for the American with a mortgage loan denominated in a foreign currency.
Internal Revenue Code Section 988
The relevant Internal Revenue Code Section is IRC Section 988 and it is a complicated tax law provision. For purposes of this post I will keep it simple. The discussion will be only by way of a broad overview.
It will help the reader to understand some basics. First, under the US tax rules, foreign currency is not viewed as “money”; it is viewed as personal property. It will help to think of foreign currency as you would any other asset such as stocks or cars.
Section 988 provides that any foreign currency gain or loss attributable to a “Section 988 transaction” is computed separately from the underlying transaction. Gain from a section 988 transaction is treated as ordinary income (i.e., there is no capital gain treatment) and loss is treated as an ordinary (not capital) loss. In general, Section 988 transactions include any disposition of any “nonfunctional currency” or becoming the obligor under a debt instrument when the amount that the taxpayer is required to pay is denominated in terms of a nonfunctional currency. The second helpful point to remember is that in the case of US individuals (even if living abroad), a “nonfunctional” currency is any currency other than the US dollar.
Let’s take a simple example of the typical American abroad, living in London. Taxpayer (T) buys a home there, in part with a mortgage loan from his friendly UK bank. How does the US tax law look at this transaction? Here’s a hint, the transaction is bifurcated into 2 separate parts – a real estate transaction, and a currency trade transaction. When T buys his home, he views the transaction as if he borrowed British pounds and then, bought his home with those pounds. The tax law does not agree. The tax law views it as if T engaged in a currency trade: T bought British pounds and then exchanged those British pounds for the house. Upon going to the bank to get a mortgage, T is treated as if he borrowed US Dollars at the then prevailing exchange rate and using those dollars to buy British pounds from the UK bank, and then later using those pounds to purchase the house. Later on when T sells the house, again the transaction will be bifurcated into a real estate transaction, and a currency trade transaction.
Certain types of transactions are excluded from application of section 988. Among them is an exception embodied in IRC Sec 988(e)(2)(B) for certain “personal transactions”. A personal transaction is generally any transaction other than a transaction which is a trade or business expense or an expense incurred in a ‘for profit’ activity. This exception applies only to gains and only if the gains do not exceed US $200. Hardly a help in the case of a mortgage debt! The personal transaction exception was enacted strictly to provide relief from the requirement to keep track of exchange gains on a transaction-by-transaction basis in de minimis cases, such as when a taxpayer is spending money on daily purchases while living or traveling abroad. If the exception does not apply, one looks to the law prior to enactment of Section 988. See e.g., Rev. Rul. 90-79, 1990-2 C.B. 187 (nicely discussed by Andrew Mitchell here). See also, Brexit Fallout: US Individual Income Tax Implications Of An Appreciating US Dollar at page 7-8.
American Abroad Getting Burned in Foreign Mortgage Foreclosure
Assume a US taxpayer living in the United Kingdom buys his personal residence there for 1,000,000 British pounds (£) when the exchange rate was $2 to £1 (USD cost $2,000,000). Assume he financed the home with a personal mortgage for £800,000, also converted at $2 = £1 (US$ 1,600,000). Let us assume that no principal was repaid, and the property was sold in foreclosure for £700,000 when the exchange rate was $1.5 to £1 (US$1,050,000), and the lending bank forgave the £100,000 difference (US$150,000).
In this example there are various separate tax transactions in play:
- First, with respect to the foreclosure sale of the real property, the taxpayer has a capital loss of US$950,000 (sales price USD value of US$1,050,000 minus taxpayer’s cost basis US$2,000,000). Unfortunately, this is a capital loss that cannot be claimed on the US tax return. A taxpayer cannot claim a capital loss on the sale of his primary residence.
- Second, with respect to the repayment of the mortgage, the taxpayer has a foreign currency gain of US$350,000. This is calculated by recalling that the creditor got £700,000 in the foreclosure proceedings and represents the difference between the USD value of the repayment amount of £700,000 at the time of the initial loan (value of USD 1,400,000) and the USD value at the time of repayment (US$1,050,000). This American abroad is in serious financial pain – he loses out on the house but cannot claim the loss, yet, he has income from the foreign currency trade. (I believe this phantom income would be taxed at capital gain rates, but there is uncertainty due to the carve out from Section 988 when gain exceeds US$200 on “personal transactions”, and prior law which points to capital gain treatment) It gets worse.
- Third, add on top, the taxpayer may also have forgiveness of indebtedness income in the amount of US$150,000 if the “qualified principal residence indebtedness exclusion” tax break is not extended and the amount is forgiven on or after January 1, 2021.
- Fourth, with respect to the amount forgiven and regardless whether the “qualified principal residence indebtedness exclusion” tax break is applied, there is a question as to the treatment of this “forgiveness” event. It is possible the taxpayer can have a foreign currency gain with respect to the £100,000 forgiven. At the time the loan was made, £100,000 had a USD value of US$200,000. At the time of the debt forgiveness, the USD value forgiven was US$150,000 resulting in a possible US$50,000 foreign currency gain (or perhaps it is considered additional income from the discharge of indebtedness). It is not clear how this is treated from a tax perspective, but I don’t think it is good! Readers with greater interest can look to Frewing, Scott, “Foreign Currency Gains and Income from Discharge of Indebtedness: Philip Morris, Inc. v. Commissioner”, The Tax Lawyer 49, No. 2 (Winter 1996), pp. 491-503.
The example illustrates how the US taxpayer abroad is left in the lurch by the US tax rules. Here, the taxpayer has a loss on the house that he cannot claim on his tax return yet, with respect to the foreclosure on his home, the Internal Revenue Service can say he has plenty of gain. Depending on the exchange rates at the relevant dates, this hapless overseas taxpayer can possibly have separate foreign currency gain on paying off the mortgage and as well as on the amount of any debt forgiven. Finally, depending on the tax rules at the time the debt is forgiven, he can have taxable income from the discharge of indebtedness. Ouch! Ouch! Ouch! And Ouch again.
Posted October 15, 2020
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