Tax consequences when foreign currency changes in value

Question

As a US taxpayer, if I hold some foreign currency that gains or loses value, what are the tax consequences when I exchange the currency for US dollars or other goods or services?

Let's take a concrete hypothetical example. Suppose in January the exchange rate of pesos to dollars is 10 pesos to the dollar. I take US$500 and exchange it for 5000 pesos.

1. Suppose in May, the peso has strengthened and the exchange rate is now 8 pesos to the dollar. If I exchange my 5000 pesos for US$625 at this rate, is my $125 profit taxable? How do I report it?

2. Suppose that instead of exchanging my pesos for dollars, I use them to buy some goods or services. Say I spend my 5000 pesos on a crate of fine tequila for which the fair market value is US$625. Do I have a taxable gain, and how do I report it?

3. Suppose instead that the peso weakened and in May the exchange rate was 15 pesos to the dollar. If I exchange my 5000 pesos for US$333, or goods or services to that value, can I deduct my loss of $166? How do I report it?

Does the taxability depend on the dollar amounts in question? If so, what are the limits?

If it makes a difference, assume that I held physical currency (rather than a bank account or similar asset), and that I am not in the business of currency trading.

This is somewhat similar to When and how should I pay taxes on ForEx trades?, but that question is specific to Israeli tax law instead of US, and also does not consider the case of exchanging for goods and services.

Answer 1

If you buy foreign currency as an investment, then the gains are ordinary income. The gains are realized when you close the position, and whether you buy something else go back to the original form of investment is of no consequence.

In case #1 you have $125 income.

In case #2 you have $125 income.

In case #3 you have $166 loss.

You report all these items on your Schedule D. Make sure to calculate the tax correctly, since the tax is not capital gains tax but rather ordinary income at marginal rates.

Changes in foreign exchange between a transaction and the conversion of the proceeds to USD are generally not considered as income (i.e.: You sold a property in Mexico, but since the money took a couple of days to clear, the exchange rate changed and you got $2K more/less than you would based on the exchange rate on the day of the transaction - this is not a taxable income/loss).

This is covered by the IRC Sec. 988. There are additional rules for contracts on foreign currency, TTM rules, etc. Better talk to a licensed tax adviser (EA/CPA licensed in your State) for anything other than trivial.