taxation on trading stocks on foreign exchanges

nero56 · Member

I'm a U.S. resident, and I have a broker account that allows
me to trade stocks on foreign exchanges ( InteractiveBrokers
). Money in the account is denominated in euros. During 2004
I've performed several trades with stocks of European
companies.

Now I'm trying to gather the info about taxation of this
income. ( BTW, I'm surprised how hard it is to find.
700-page "2005 income tax" book does not even touch this
subject. There seems to be no direct data on the IRS site,
either. ) From what I've managed to gather, I see the
following picture.

1. Each transaction is treated as if it were performed in
dollars, using the exchange rate on the date it took place.
E.g. if I bought 100 shares of X for 10 euros each when
exchange rate was 1 euro = $1.20 and sold them for 10 euros
when 1 euro = $1.22, I have capital gains of $20.

2. Euro exchange rate has risen since the time I've
converted money in the account into euros. However, I don't
have to pay taxes on this gain until I convert money back
into dollars.

Can anyone confirm or disprove this?

Thanks

MisterL · Member

The rules dealing with foreign currency are complex. Many
of the rules are contained in section 988 of the Internal
Revenue Code and in the 988 regulations.

You should treat the foreign currency as though is it
property and not as though it is money. IRC Sec.
988(c)(1)(C). As a US person with most of your transactions
denominated in US dollars, your "functional currency" is US
dollars. IRC Sec. 985(b). When you buy or sell foreign
currency it is as though you are buying or selling property.

Once you start to think in terms that foreign currency is
property, you need to understand that an "exchange" of
property is taxable just like a sale of property. Thus, if
you "exchange" foreign currency for stock or another asset,
you will recognize a currency gain or loss.

For example, you take $120 and convert it into 100 Euros
(exchange rate of 1 Euro = $1.20). You have purchased
property with a tax basis of $120. IRC Sec. 985(a). If you
immediately take the 100 Euros and purchase an investment,
then you have exchanged one type of property (foreign
currency) for another (stock). This exchange is a taxable
transaction. Because the purchase of Euros was immediately
followed by the purchase of stock, your currency gain or
loss was zero.

If you converted the dollars into Euros, but delayed the
purchase of the stock, then when you bought the stock, you
would have a potential currency gain or loss on the Euros
(assuming exchange rates changed). Remember, your US tax
basis in the 100 Euros is $120. If the exchange rate is 1
Euro = $1.22 (Euro has appreciated) on the date you purchase
the stock, then you have a gain on the Euros. Tax basis in
the Euros is $120 and FMV of the Euros is 122. Thus, you
have a currency gain of $2.

Since you acquired the stock with Euros that had a FMV of
$122, your US tax basis in the stock is $122.

When you sell the stock for Euros, you have exchanged stock
for Euros. This exchange will require the recognition of
gain or loss. Continuing the example in the immediately
preceeding paragraph, your US tax basis in the stock was
$122. If you sell the stock and receive 105 Euros and the
exchange rate on the date of sale is 1 Euro = $1.24, then
the value of the stock on the date of the sale was $130.20
(105 X 1.24). You have a gain (presumably capital) on the
exchange of the stock of $8.20 [130.2-122].

You have disposed of stock and acquired 105 Euros. Your US
tax basis in the Euros is now $130.20. When you dispose of
those Euros you will again calculate a gain or loss. Just
about any type of disposition of the Euros will trigger gain
or loss, including converting the Euros into US dollars.

You also need to consider the character of the gain or loss.
As mentioned above, the gain on the exchange of the stock
of $8.20 was probably capital gain. However, currency gains
and losses when engaging in investment type activities are
ordinary gains and losses. IRC Sec. 988(a)(1)(A) and 988(e).

Another question (which I don't know the answer to) is
whether the currency gains and losses are netted to come up
with net ordinary gain or loss. This could be important
because investment related currency losses will be subject
to the 2% floor on miscellaneous itemized deductions. The
question is whether the gross amount of the currency gains
must be included "above the line" and then the gross amount
of the losses shown "below the line" (similar to gamblers),
or whether a net gain (loss) is shown above (below) the
line.

Good luck. Idea