1996 WL 33658419 (1st Cir.)
For opinion see 93 F.3d 26
United States Court of Appeals, First
Circuit.
Carlos J. QUIJANO and Jean M. Quijano,
Plaintiffs-Appellants,
v.
UNITED STATES OF AMERICA,
Defendant-Appellee.
No. 96-1053.
April 22, 1996.
On Appeal From the Judgment of the United
States District Court for the District of Maine
Brief for the United States
Loretta C. Argrett, Assistant Attorney
General, Gary R. Allen (202) 514- 3361, Richard Farber (202) 514-2959, Kenneth
W. Rosenberg (202) 514-1919, Attorneys, Tax Division, Department of Justice,
Post Office Box 502, Washington, D.C. 20044, Of Counsel: Jay P. McCloskey,
United States Attorney.
*i TABLE OF CONTENTS
Statement of subject matter and appellate
jurisdiction ... 1
Statement of the issue ... 2
Statement of the case ... 2
Summary of argument ... 6
Argument:
The district court correctly determined
the amount of gain taxpayers realized on the sale of their foreign residence,
and correctly held that the foreign exchange loss realized by taxpayers on the
mortgage loan for the residence was nondeductible ... 8
Standard of review ... 8
A. Introduction: United States taxation of
foreign property transactions and foreign currency debts ... 8
B. Taxpayers realized a gain on the sale of
their London residence and a nondeductible exchange rate loss from repayment of
the associated mortgage loan ... 14
C. Taxpayers' arguments are without merit
... 18
Conclusion ... 24
Appendix ... 26
CITATIONS
Cases:
Bennett's Travel Bureau, Inc. v.
Commissioner, 29 T.C. 350 (1957) ... 12, 14
Bernuth Lembcke Co. v. Commissioner, 1
B.T.A. 1051 (1925) ... 14
Bohm v. Commissioner, 34 T.C. 929 (1960)
... 16
Bowers v. Kerbaugh-Empire Co., 271 U.S.
170 (1926) ... 20
Church's English Shoes, Ltd. v.
Commissioner, 229 F.2d 957 (2d Cir. 1956), aff'g 24 T.C. 56 (1955) ... 13, 17
Commissioner v. Glenshaw Glass Co., 348
U.S. 426 (1955) ... 20
*ii Federal National Mortgage Ass'n v.
Commissioner, 100 T.C. 541 (1993) ... 9, 10, 12
G.M. Trading Corp. v. Commissioner, 103
T.C. 59 (1994) ... 11
Gillin v. United States, 423 F.2d 309 (Ct.
Cl. 1970) ... 9
Joyce-Koebel Co. v. Commissioner, 6 B.T.A.
403 (1927) ... 14
KVP Sutherland Paper Co. v. United States,
344 F.2d 377 (Ct. Cl. 1965) ... 11
National-Standard Co. v. Commissioner, 80
T.C. 551 (1983), aff'd, 749 F.2d 369 (6th Cir. 1984) ... 9, 10
Philip Morris Inc. v. Commissioner, 104
T.C. 61 (1995), aff'd, 71 F.2d 1040 (2d Cir. 1995), pet. for cert. pending
(S.Ct. No. 95-1420) ... 9, 20
Puttkammer v. Commissioner, 66 T.C. 240
(1976) ... 16
Seaboard Finance Co. v. Commissioner, 225
F.2d 808 (9th Cir. 1955) ... 14
Vukasovich, Inc. v. Commissioner, 790 F.2d
1409 (9th Cir. 1986) ... 20
Willard Helburn, Inc. v. Commissioner, 214
F.2d 815 (1st Cir. 1954) ... 7, 12, 13, 17, 19
Statutes:
Internal Revenue Code (26 U.S.C.):
§ 61 ... 11, 23
§ 105 ... 7
§ 108 ... 21
§ 165 ... 7, 16, 17, 23
§ 985 ... 5, 8
§ 988 ... 8, 9
§ 989 ... 8
§ 1001 ... 12
§ 1011 ... 12
§ 1012 ... 12
§ 6532 ... 1, 11
Tax Reform Act of 1986, Pub. L. No.
99-514, 100 Stat. 1085, §§ 1012, 1261 ... 8
*iii 28 U.S.C.:
§ 636 ... 5, 6
§ 1291 ... 2
§ 1346 ... 1
§ 2107 ... 2
Miscellaneous:
B. Bittker & L. Lokken, Federal
Taxation of Income, Estates and Gifts, 1995 Cum. Supp. No. 3 ¶ 71.13
at pp. S71-85 ... 18
Federal Rules of Appellate Procedure: Rule
4 ... 2
H.R. Conf. Rep. No. 841, 99th Cong., 2d
Sess. II-669 (1986-3 C.B. (Vol. 4) 669) ... 9
II J. Isenbergh, International Taxation
(1990) ... 8, 11
7 J. Mertens, Law of Federal Income
Taxation, § 28-148 at p. 383 (1996) ... 10
P. Miller, Foreign Currency Transactions:
A Review of Some Recent Developments, 33 Tax Lawyer 825 (1980) ... 10
D. Ravenscroft, Taxation and Foreign
Currency (1973) ... 10, 15
Rev. Rul. 54-105, 1954-1 C.B. 12 ... 12,
15
Rev. Rul. 71-134, 1971-1 C.B. 75 ... 16
Rev. Rul. 78-281, 1978-2 C.B. 204, 205 ...
12, 17
Rev. Rul. 90-79, 1990-2 C.B. 187 ... 17,
18
S. Rep. No. 313, 99th Cong., 2d Sess. 469
(1986-3 C.B. (Vol. 3) 469) ... 9, 10
L. Samuels, Federal Income Tax
Consequences of Back-to-Back Loans and Currency Exchanges, 33 Tax Lawyer 847,
863 (1980) ... 12
Treasury Regulations:
§ 1.988-1(a)(9) ... 9
§ 1.989-1(c) ... 8
*1 STATEMENT OF SUBJECT MATTER AND
APPELLATE JURISDICTION
Taxpayers Carlos J. Quijano and Jean M.
Quijano filed a claim for refund of $30,610 in federal income taxes for their
1990 taxable year. (A. 12-13.) [FN1] On January 14, 1994, the Internal Revenue
Service denied the claim. (A. 14.) On December 5, 1994, taxpayers filed a
complaint in the United States District Court for the District of Maine,
seeking to recover the claimed refund. (A. 1.) The complaint was timely under
Internal Revenue Code § 6532(a) (26 U.S.C.). The district court had
jurisdiction under 28 U.S.C. § 1346(a)(1).
FN1.
"A." references are to the separately bound record appendix.
"Appendix" references are to the statutory appendix to this brief.
In the district court, taxpayers filed a
motion for summary judgment, arguing that they were entitled to judgment as a
matter *2 of law for the claimed refund. (A. 8.) The United States filed a
motion for partial summary judgment, admitting that taxpayers were entitled to
judgment for a portion of the claimed refund (later stipulated to be $2,668
plus interest and penalties (A. 19)), but seeking to limit the judgment to that
amount. (A. 10.)
On December 19, 1995, the district court
entered judgment in favor of taxpayers for $2,668, plus interest and penalties
as provided by law. (A. 40.) The judgment was a final order that disposed of
all claims with respect to all parties. On January 8, 1996, taxpayers filed
this appeal. (A. 41.) The appeal was timely under 28 U.S.C. § 2107 and
Rule 4(a)(1) of the Federal Rules of Appellate Procedure. This Court has
jurisdiction under 28 U.S.C. § 1291.
STATEMENT OF THE ISSUE
Whether the district court correctly
determined the amount of the gain realized by taxpayers on the sale of their
foreign residence, and correctly held that the foreign exchange loss taxpayers
realized on their mortgage loan for the residence was not deductible.
STATEMENT OF THE CASE
The relevant facts are undisputed and may
be summarized as follows.
Taxpayers are residents of the United
States. (A. 12.) In 1986, taxpayer Carlos Quijano's employer, Chase Manhattan
Bank, N.A., transferred him to a post of duty in England. (A. 13.)
*3 On September 30, 1986, taxpayers
purchased a residence located at 70 Dukes Avenue, Chiswick, London, England,
for a price of £297,500. (A. 13.) Taxpayers paid the entire purchase price with
the proceeds of a mortgage loan from Chase Manhattan Bank. (Ibid.) Between 1987
and 1990, taxpayers made capital improvements to the residence costing £45,647.
(A. 13, 16.)
On or about October 12, 1988, taxpayers
refinanced the mortgage loan, increasing the principal amount to £330,000. (A.
13.) On or about March 27, 1990, taxpayers refinanced the mortgage again,
increasing the principal again to £333,180. (A. 13-14.) On July 27, 1990,
taxpayers sold the residence for a price of £453,374, net of selling expenses.
(A. 14.)
On their 1990 joint federal income tax
return, taxpayers reported a capital gain in the amount of $308,811 from the
sale of the residence. To determine their adjusted basis in the residence,
taxpayers used the exchange rate in effect at the time of purchase, which was
$1.49 U.S. to £1. Taxpayers later filed an amended return, using the exchange
rate in effect at the time of sale, $1.82 U.S. to £1, to determine their
adjusted basis. (A. 14.) Computed in that manner, the gain on the sale was $199,491.
(A. 13.) Accordingly, on their amended return taxpayers claimed a refund in the
amount of $30,610. (A. 14.) The Internal Revenue Service denied the claim, and
this suit followed.
Taxpayers moved for summary judgment in
the district court. They contended that the gain they realized on the sale of
their *4 residence should be computed in British pounds, by subtracting their
adjusted basis in the residence (expressed in pounds) from the amount realized
on the sale (also expressed in pounds), and then should be converted into U.S.
dollars by applying the exchange rate applicable on the date of the sale.
Computed in this manner, taxpayers realized a gain of $199,491 on the sale of
their residence.
The United States filed a cross motion for
partial summary judgment. The Government maintained that taxpayers were
required to compute the gain on the sale of their residence by using the
exchange rate applicable on the date they purchased the residence to determine
their adjusted basis in the property (expressed in U.S. dollars) and then
subtracting that amount from the amount realized on the sale (also expressed in
U.S. dollars) using the exchange rate applicable on the date of sale. Computed
in this manner, taxpayers realized a gain of approximately $300,000 on the sale
of the residence, as they had reported on their original tax return. [FN2]
FN2.
Although the Government asserted that taxpayers had used the proper method in
computing their gain on their original return, the Government maintained that
they had made a computational error that resulted in a small overpayment of
their tax. (A. 10-11.) The parties subsequently stipulated that, in the event
the Government prevailed on its theory of the case, taxpayers were entitled to
a refund in the amount of $2,668.00 plus interest.
The case was referred to United States
Magistrate Judge David M. Cohen, who filed a recommended decision stating that
partial summary judgment should be rendered in favor of the *5 United States.
(A. 21.) See 28 U.S.C. § 636(b)(1)(B). The Magistrate Judge noted that
under Section 985 of the Internal Revenue Code, Appendix, infra, taxpayers'
"functional currency" was the United States dollar. Consequently,
taxpayers were required to make all income tax determinations, including the
computation of gain or loss from the sale of the residence, in U.S. dollars.
(A. 23.) The Magistrate Judge further determined that taxpayers' mortgage loan
was to be treated as a separate transaction from the purchase and sale of their
residence, and that any loss realized on repayment of the loan due to
fluctuation in exchange rates could not be offset against any gain realized on
the sale of the residence. (A. 23- 24.) The Magistrate Judge accordingly held
that in computing their gain from the sale of the residence, taxpayers were
required to determine the cost and selling price using the exchange rates
prevailing as of the date of the purchase and the date of the sale,
respectively, and the cost of capital improvements was to be determined using the
exchange rates prevailing when payments for those improvements were made. (A.
25.) Finally, the Magistrate Judge rejected taxpayers' argument that the gain
realized on the sale of the house, to the extent such gain was attributable to
a change in exchange rates, was not constitutionally taxable as income. (A.
25-26.)
The district court (Chief Judge Gene
Carter) "concurr[ed] with the recommendations of the United States
Magistrate Judge for the reasons set forth in his Recommended Decision,"
and *6 affirmed the recommended decision. (A. 38-39.) See 28 U.S.C. §
636(b)(1). Pursuant to the stipulation of the parties (A. 19), judgment was
entered in favor of taxpayers in the amount of $2,668.00 plus interest. (A.
40.) This appeal by taxpayers followed.
SUMMARY OF ARGUMENT
This case concerns the federal income tax
consequences of the purchase and sale by United States taxpayers of a personal
residence located in London, England. The home was purchased with English
pounds, which taxpayers obtained through a mortgage loan. Under
well-established law, the taxpayers' basis in the residence is determined by
converting the purchase price into U.S. dollars at the exchange rate prevailing
at the time of the purchase, and the amount realized from the sale is
determined by converting the proceeds into U.S. dollars at the rate prevailing
at the time of the sale. Under that method of computation taxpayers realized a
taxable gain of approximately $300,000 on the sale.
When a United States taxpayer borrows
money in a foreign currency and uses the loan proceeds to purchase an asset,
the loan transaction is treated as a transaction separate from the acquisition
of the asset. When taxpayers here repaid their mortgage loan, they incurred a
loss because the value of the pound sterling (as measured against the dollar)
had increased since the time they obtained the loan. That loss, however, is not
deductible because, with limited exceptions not applicable *7 here, Section 165
of the Internal Revenue Code provides that losses incurred by an individual
that do not arise in a trade or business or in a transaction entered into for
profit are nondeductible.
Taxpayers argue that, because they did not
convert pounds into dollars in purchasing their residence, the increase in the
value of the pound between the date they purchased the residence and the date
they sold it should be ignored in computing the gain on the sale. Taxpayers
contend that the gain on the sale, measured in pounds, should simply be
converted to dollars at the exchange rate prevailing at the time of the sale.
That treatment is contrary to the well-established principle that foreign
currency is treated as property, rather than money. Applying that principle,
this Court held in Willard Helburn, Inc. v. Commissioner, 214 F.2d 815 (1st
Cir. 1954), that where a United States taxpayer purchases property with
borrowed foreign currency, a gain or loss arises upon repayment of the loan, as
a result of fluctuation in exchange rates between the time of the borrowing and
the repayment, and that such gain or loss is independent of any gain or loss
realized on the disposition of the property purchased with the borrowed funds.
The district court here correctly applied
the principles set out in Willard Helburn, Inc. in determining the amount of
the gain realized by taxpayers on the sale of their residence. Its decision
should be affirmed.
*8 ARGUMENT
THE DISTRICT COURT CORRECTLY DETERMINED
THE AMOUNT OF GAIN TAXPAYERS REALIZED ON THE SALE OF THEIR FOREIGN RESIDENCE,
AND CORRECTLY HELD THAT THE FOREIGN EXCHANGE LOSS REALIZED BY TAXPAYERS ON THE
MORTGAGE LOAN FOR THE RESIDENCE WAS NONDEDUCTIBLE
Standard of review
The granting of summary judgment is
reviewable de novo.
A. Introduction: United States taxation of
foreign property transactions and foreign currency debts
Prior to 1986, United States taxation of
transactions involving foreign currencies was controlled by common law. See II
J. Isenbergh, International Taxation ¶¶ 35.1 to 35.4 (1990).
In 1986, Congress enacted a statutory scheme to govern the area. Tax Reform Act
of 1986, Pub. L. No. 99-514, 100 Stat. 1085, §§ 1012, 1261,
enacting Internal Revenue Code §§ 985-989 (26 U.S.C.). Under
Section 985 of the Code, transactions generally are accounted for in the
taxpayer's "functional currency." The functional currency of a U.S.
citizen or resident is the U.S. dollar, except in the case of a separate business
unit that keeps books and records in a foreign currency. I.R.C. §§
985(b)(1), 989(a). It is undisputed here that taxpayers' functional currency is
the U.S. dollar. (Br. 8.) See Treas. Reg. § 1.989-1(c).
Section 988 of the Code prescribes
specific rules for accounting for transactions in currencies other than the
taxpayer's functional currency. Section 988 does not apply, however, to foreign
currency transactions of an individual that *9 are made for personal rather
than business or investment reasons. I.R.C. § 988(e); Treas. Reg. §
1.988-1(a) (9). The legislative history of the Tax Reform Act of 1986 provides
in this regard as follows:
[S]ection
988 is inapplicable to exchange gain or loss recognized by a U.S. individual
resident abroad upon repayment of a foreign currency denominated mortgage upon
the individual's principal residence. The principles of current law would
continue to apply to such transaction.
S. Rep. No. 313, 99th Cong., 2d Sess. 469
(1986-3 C.B. (Vol. 3) 469); accord H.R. Conf. Rep. No. 841, 99th Cong., 2d
Sess. II-669 (1986-3 C.B. (Vol. 4) 669).
Principles of law governing transactions
of United States taxpayers in foreign currencies were developed prior to 1986,
and subsequently have been confirmed and further refined by the courts. In the
hands of a United States taxpayer, foreign currency is considered property.
Philip Morris Inc. v. Commissioner, 71 F.3d 1040, 1042 (2d Cir. 1995), pet. for
cert. pending (S.Ct. No. 95- 1420); Federal National Mortgage Ass'n v.
Commissioner, 100 T.C. 541, 582 (1993); National-Standard Co. v. Commissioner,
80 T.C. 551, 555 (1983), aff'd, 749 F.2d 369 (6th Cir. 1984); Gillin v. United
States, 423 F.2d 309, 311 (Ct. Cl. 1970); H.R. Conf. Rep. No. 841 at II-662
(1986-3 C. B. (Vol. 4) 662). The borrowing and repayment of foreign currency,
on the one hand, and the investment in and sale of property acquired with the
proceeds of foreign currency loans, on the other, are treated as separate
transaction for purposes of determining gain *10 or loss. Federal National
Mortgage Ass'n v. Commissioner, 100 T.C. at 582; National-Standard Co. v.
Commissioner, 80 T.C. at 555 ("the acquisition and disposition of foreign
currency used to make an investment is a separate transaction from the
underlying transaction and ... gain or loss thereon must be accounted for
separately"); 7 J. Mertens, Law of Federal Income Taxation, §
28-148 at p. 383 (1996); D. Ravenscroft, Taxation and Foreign Currency 54
(1973) ("[e]ven when ... a foreign currency receivable or obligation is
related to the purchase or disposition of other property or services, most
decisions have treated the exchange-rate-change gains and losses on such items
as separate gains and losses rather than adjustments to basis or sales
price"); P. Miller, Foreign Currency Transactions: A Review of Some Recent
Developments, 33 Tax Lawyer 825, 825-28 (1980) (dubbing this "the
two-transaction principle"). Indeed, it is readily apparent that a U.S.
taxpayer who invests in foreign property and who finances the investment by
borrowing foreign currency stands to gain or lose separately on the investment
and the loan, based upon fluctuations in the value of the foreign currency
vis-a-vis the U.S. dollar.
In the legislative history of the Tax
Reform Act of 1986, Congress summarized the tax treatment of gains and losses
resulting from fluctuations in exchange rates (S. Rep. No. 313 at 433 (1986-3
C.B. (Vol. 3) 433)) (footnotes omitted):
When
a U.S. taxpayer uses foreign currency, gain or loss (referred to as
"exchange gain or loss") may arise from fluctuations in the value of
the foreign *11 currency in relation to the U.S. dollar. This result obtains
because foreign currency is treated as personal property, and not as equivalent
to the U.S. dollar, for Federal income tax purposes.
*
* *
Foreign
exchange gain or loss can arise in the course of a trade or business or in
connection with an investment transaction. Exchange gain or loss can also arise
where foreign currency is acquired for personal use. Under the so-called
"separate transactions principle," both the courts and the IRS
require that exchange gain or loss be separately accounted for, apart from any
gain or loss attributable to an underlying transaction. [FN3]
FN3.
Taxpayers attempt to avoid separate treatment of the sale and the repayment of
the loan by claiming (Br. 22) that they did not "acquire foreign currency
for personal use." They did, however, borrow foreign currency; the fact
that they may not have held the currency in their hands (or as a bank deposit),
but applied the loan proceeds directly to the purchase of the residence, is
immaterial. This point also disposes of taxpayers' assertion (Br. 22) that the
"separate transaction principle" is limited to the context of
"business transactions."
Because transactions involving foreign
currencies are treated as transactions in property, the usual rules for taxing
gain or loss from sales of property apply. See G.M. Trading Corp. v.
Commissioner, 103 T.C. 59, 67 (1994); KVP Sutherland Paper Co. v. United
States, 344 F.2d 377, 380-81 (Ct. Cl. 1965); Ravenscroft, Taxation and Foreign
Currency at 200; II Isenbergh, International Taxation ¶ 35.2 at p.
280. Gains derived from dealings in property are included in gross income.
Internal Revenue Code § 61(a)(3). The amount of gain or loss realized
upon the sale of property is equal to the difference between the adjusted basis
of the property sold and the cash or fair market *12 value of other property
received in exchange. I.R.C. § 1001(a), (b); see I.R.C. §§
1011(a), 1012 (basis generally equals cost).
For purposes of computing gain or loss on
transactions involving foreign currency, the cost basis of the currency or
property acquired with foreign currency is expressed in U.S. dollars at the
rate of exchange prevailing as of the date of purchase. Rev. Rul. 54-105,
1954-1 C.B. 12; Federal National Mortgage Ass'n v. Commissioner, 100 T.C. at
582; Bennett's Travel Bureau, Inc. v. Commissioner, 29 T.C. 350, 353 (1957).
Similarly, the selling price of such currency or property is expressed in U.S. dollars
at the rate of exchange prevailing as of the date of the sale. Rev. Rul.
54-105. Accord Rev. Rul. 78-281, 1978-2 C.B. 204, 205; L. Samuels, Federal
Income Tax Consequences of Back-to-Back Loans and Currency Exchanges, 33 Tax
Lawyer 847, 863 (1980). Thus, where a U.S. taxpayer borrows foreign currency,
upon repayment a gain or loss will be realized where the principal amount
repaid, expressed in U.S. dollars, is different from the amount borrowed,
expressed in U.S. dollars, due to fluctuation in exchange rates. Rev. Rul.
78-281.
The foregoing principles were applied by
this Court in Willard Helburn, Inc. v. Commissioner, 214 F.2d 815 (1st Cir.
1954). The taxpayer in that case, a United States corporation, purchased
lambskins in New Zealand for pounds sterling. The taxpayer's bank paid for the
skins and issued drafts payable by the taxpayer in pounds sterling within 120
days. "By this arrangement, petitioner necessarily involved itself in a
*13 speculation on foreign exchange." 214 F.2d at 818. The cost of the
skins to the taxpayer was determined by applying the exchange rate in effect at
the time of purchase, although payment by taxpayer was deferred. Between the
time the drafts were issued and paid, the pound was devalued, so that the
taxpayer was able to satisfy the obligation with fewer dollars than if it had
paid the obligation immediately upon the sale. This Court held that the gain
thus realized was includable in the taxpayer's gross income as a gain "on
its speculation in foreign exchange," independent of any gain or loss
realized on the sale of the lambskins. Id. at 819.
Similarly, in Church's English Shoes, Ltd.
v. Commissioner, 229 F.2d 957 (2d Cir. 1956), aff'g 24 T.C. 56 (1955), the
taxpayer purchased shoes from its parent company, incurring an obligation to
pay in pounds sterling. The shoes were added to inventory at then-current
exchange rates. The debt was not repaid until some years later, when the value
of the pound sterling had declined in relation to the U.S. dollar. The court
held that the savings thus realized were includable in gross income as a gain
on the foreign exchange transaction. "[T]he proper method of accounting is
to account for any profit or loss in the payment for foreign exchange in and as
a transaction which is separate from the purchase and sale of the shoes. There
were two transactions, for accounting and tax purposes, one involving the
purchase and sale of shoes, the other a 'speculation' in foreign
exchange." 24 T.C. at 59. To the same effect, *14see Seaboard Finance Co.
v. Commissioner, 225 F.2d 808, 816 (9th Cir. 1955) (taxpayer realized exchange
rate gain from deposit of Canadian dollars pending payment to consummate
corporate acquisition); Bennett's Travel Bureau, Inc. v. Commissioner, 29 T.C.
at 354-56 (travel agency realized exchange gain, due to devaluation of
Norwegian kroner, upon repayment in kroner of vacation expenses paid in advance
by customers); Joyce-Koebel Co. v. Commissioner, 6 B.T.A. 403, 406 (1927)
("the proper method of accounting is to include purchases in the accounts
at the rate of exchange prevailing at the date of purchase and to account for
any profit or loss in the payment therefor as a separate transaction");
Bernuth Lembcke Co. v. Commissioner, 1 B.T.A. 1051, 1054 (1925) (where taxpayer
contracted to buy pounds sterling at fixed rate in order to purchase inventory
in England, but exchange rate of pounds sterling declined before purchase was
actually made and contract executed, payment made under contract in excess of
market exchange rate was deductible loss).
B. Taxpayers realized a gain on the sale
of their London residence and a nondeductible exchange rate loss from repayment
of the associated mortgage loan
In the present case, taxpayers purchased a
personal residence in London, borrowing pounds sterling to finance the entire
purchase price. Four years later, after refinancing the mortgage twice and
after investing additional amounts in the home, taxpayers sold the residence.
The relevant transactions may be summarized as follows (A. 13-14):
*15 Thus, the dollar decreased in value in
relation to the pound during the time taxpayers owned the London residence.
Under the well-established principles of
U.S. taxation of foreign currency transactions discussed above, the tax
consequences of those transactions are clear. Upon sale of the home, taxpayers
realized a gain equal to the excess of the amount realized--the sale proceeds
converted to U.S. dollars at the exchange rate prevailing at the time of the
sale--over the adjusted basis--the purchase price and the cost of the
improvements, converted to U.S. dollars at the exchange rates prevailing at the
time of the purchase and the time the cost of the improvements was paid,
respectively. Because of the increase in the value of the pound in relation to the
U.S. dollar between the time of the purchase and sale, the proceeds from the
sale were greater, in U.S. dollars, than they would otherwise have been. To the
extent taxpayers profited from the change in exchange rates, that gain was
subsumed in the gain on the sale of the residence. See Ravenscroft, Taxation
and Foreign Currency at 71-72; Rev. Rul. 54-105.
*16 In addition, upon repayment of the
mortgage loan, including each of the refinancing transactions, taxpayers
realized an exchange rate gain or loss. Because of the increase in the value of
the pound in relation to the dollar between the time of the final refinancing
and the repayment of the loan, taxpayers had to repay more than they borrowed
in terms of U.S. dollars. That loss was solely attributable to the change in
exchange rates.
The deductibility of losses is governed by
Section 165 of the Internal Revenue Code, Appendix, infra. Under Section
165(c), losses incurred by individual taxpayers are deductible only if they
arise from a trade or business, from a transaction entered into for profit,
from fire, storm, shipwreck, or other casualty, or from theft. Because the
taxpayers' loss arose from the changes in the exchange rate with respect to the
loan they took out to finance their personal residence, the loss is not
deductible. See Bohm v. Commissioner, 34 T.C. 929, 930 (1960) (exchange loss
incurred upon repayment to taxpayer of loan denominated in pounds sterling was
not deductible because loan "was not ...a profit-oriented
undertaking" and loss was not a casualty loss); Rev. Rul. 71-134, 1971-1
C.B. 75 (taxpayer who sold personal vehicle in foreign country for foreign
currency incurred nondeductible personal loss when currency was devalued before
being exchanged for dollars); see also Puttkammer v. Commissioner, 66 T.C. 240,
243 (1976) (loss incurred on exchange of U.S. dollars for Indian rupees was
personal and therefore nondeductible).
*17 The situation here is essentially the
same as the situation addressed in Rev. Rul. 90-79, 1990-2 C.B. 187. There, a
United States taxpayer purchased a personal residence in a foreign country,
financing the bulk of the purchase price with a loan. Three years later, the
taxpayer sold the residence and repaid the loan. Because taxpayer's functional
currency was the U.S. dollar, and no expenses in connection with the property
were deductible as trade or business expenses or as expenses relating to
production of income, all income tax determinations were made using the U.S.
dollar. For the same reason, the pre-1986 common law rules governing foreign
currency transactions applied. The taxpayer's basis in the residence was
determined using the exchange rate in effect at the time of the purchase. The
amount realized was determined using the exchange rate in effect at the time of
the sale. Based on this method of computation, the taxpayer was determined to
have realized a taxable gain on the sale.
The borrowing and repayment of the loan
was treated in the Revenue Ruling as a separate transaction from the purchase
and sale of the personal residence. Rev. Rul. 90-79, 1990-2 C.B. at 188, citing
Willard Helburn, Inc.; Church's English Shoes; Rev. Rul. 78-281. Since the
foreign currency increased in value against the dollar during the time the
taxpayer owned the residence, the taxpayer paid more, in dollar terms, to repay
the loan than he received when the loan was made. The resulting loss, however,
was not deductible under § 165, the ruling *18 concluded, because it
was not incurred in a trade or business or a transaction entered into for
profit and was not a casualty loss. Nor could the loss be offset against the
gain on the sale of the residence. See B. Bittker & L. Lokken, Federal
Taxation of Income, Estates and Gifts, 1995 Cum. Supp. No. 3 ¶ 71.13
at pp. S71-85 to -86.
Rev. Rul 90-79 illustrates the correct
method of determining the gain or loss on the sale of a personal residence in a
foreign country, and determining the tax consequences of the repayment of a
loan that was used to finance the purchase of the residence. On their original
return, taxpayers used this method in computing the gain on the sale of their
residence. The method of computation used by taxpayers in their amended return,
however, in which they, in effect, ignored the changes in the exchange rule in
determining the amount of their gain, is improper, as the district court
correctly held.
C. Taxpayers' arguments are without merit
Taxpayers take the position that the
change in the exchange rate of pounds sterling to U.S. dollars between the date
they purchased their residence and the date they sold it should be ignored in
determining the amount of their gain on the sale. In their view, the gain
should be computed by subtracting their adjusted basis in the property
(expressed in pounds) from the amount realized on the sale (also expressed in
pounds), and then converting the resulting figure to U.S. dollars by applying
the exchange rate applicable on the date of the sale. Taxpayers *19 claim that
the method of computation set forth in Revenue Ruling 54-105 and applied by the
Internal Revenue Service in this case is improper and results in the taxation
of unrealized gain because they never converted pounds to U.S. dollars in
purchasing their residence.
Taxpayers' argument is misconceived. They
ignore the fact that in purchasing property with a foreign currency they
necessarily put themselves in a position to realize an economic gain or incur
an economic loss solely as a result of a change in the exchange rate. As this
Court explained in Willard Helburn, Inc., by purchasing property with foreign
currency, taxpayers "necessarily involved [themselves] in a speculation on
foreign exchange." 214 F.2d at 818. Thus, contrary to the central premise
of their argument, it makes no difference that taxpayers did not convert pounds
to dollars in purchasing their residence. If a United States taxpayer purchases
property for £100,000 at a time when that amount of pounds is worth $150,000
and subsequently sells the property for £100,000 at a time when the pounds are
worth $175,000, the taxpayer clearly has realized a taxable gain of $25,000,
attributable solely to the change in the exchange rate, notwithstanding that
the entire transaction was carried out in pounds. See Rev. Rul. 54-105, 1954-1
C.B. 12. That is precisely the situation presented here. Taxpayers realized
gain on the sale of their residence that was attributable in part to the
appreciation in value of the property and in part to the appreciation in value
(against the dollar) of *20 the foreign currency they used to purchase the
property. The entire amount of such gain was realized and hence taxable.
Taxpayers' argument that the Government's
position results in the unconstitutional taxation of "unrealized"
gain is founded on the erroneous premise, discussed above, that a United States
taxpayer does not realize any gain or loss from a transaction carried out in a
foreign currency unless the foreign currency has been converted into dollars in
connection with such transactions. As we have shown, a taxpayer who purchases
property with a foreign currency necessarily has placed himself in a position
to gain or lose from a change in the exchange rate, even though there was no
conversion of the foreign currency into U.S. dollars. If the property is sold
at a time when the foreign currency has increased in value (as measured against
the dollar) from the time the property was purchased, the resulting gain
clearly is realized and fully taxable under the Constitution. See Commissioner
v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955) (gross income taxable under the
Internal Revenue Code encompasses all accessions to wealth.) [FN4]
FN4.
Taxpayers' reliance on the decisions in Bowers v. Kerbaugh-Empire Co., 271 U.S.
170 (1926), and Philip Morris Inc. v. ??, 104 T.C. 61 (1995), aff'd, 71 F.3d 1040
(2d Cir. 1995), is misplaced. As the Ninth Circuit held in Vukasovich, Inc. v.
Commissioner, 790 F.2d 1409, 1413- 17 (1986), the decision in Bowers has been
sapped of all continuing vitality by subsequent decisions of the Supreme Court.
The decision in Philip Morris, Inc. similarly does nothing to advance
taxpayers' case. The taxpayer in that case obtained several loans in various
foreign currencies, which it subsequently repaid in those same currencies.
Because the value of the foreign currencies declined in value against the
dollar between the dates the loans were obtained and repaid, the taxpayer
conceded that it realized taxable gain on the loan transactions. The issue in
the case was whether the income admittedly realized by the taxpayer constituted
income from the discharge of indebtedness within the meaning of Section 108 of
the Code, so as to allow the taxpayer to spread the income over a number of
years. The Tax Court's rejection of the taxpayer's contention that the income
qualified as income from the discharge of indebtedness, affirmed by the Second
Circuit, has no possible bearing on taxpayers' claim in the instant case that
they realized no foreign exchange gain because they never converted their
pounds into dollars.
*21 Equally meritless is taxpayers'
related argument that, because they borrowed the funds used to purchase their
residence, the loan transaction should be treated as an integral part of their
purchase and sale of the property, so that, in effect, the foreign exchange gain
they realized on the sale of their residence would be largely offset by the
foreign exchange loss they incurred on the loan transaction. It is well
settled, as explained above (pp. 9-12), that when a United States taxpayer
borrows foreign currency to purchase an asset, the loan is a separate
transaction from the acquisition of the asset and that, consequently, if the
exchange rate changes between the date the loan is obtained and the date the
loan is repaid, the taxpayer realizes a foreign exchange gain or loss on the
loan transaction irrespective of any gain or loss realized on the disposition
of the asset acquired with the borrowed funds. The gain or loss realized on a
foreign currency loan is a function of the change, if any, in the applicable
exchange rate between the date the loan is obtained and the date the loan is
repaid. If the value of the foreign currency (measured in dollars) increases
between the date *22 the loan is obtained and the date the loan is repaid, the
taxpayer would realize a loss on the loan transaction, whereas he would realize
a gain if the value of the foreign currency declined in the interim. This
result would obtain regardless of any gain or loss realized by the taxpayer on
the disposition of the asset acquired with the borrowed funds.
The principles set forth above may be
illustrated by the following example: Assume a United States taxpayer borrows £1,000,000
to purchase a factory and executes a promissory note requiring repayment of the
loan in 5 years. Assume further that the taxpayer repays the loan on time, that
on the date the loan is repaid the value of the £1,000,000 (measured in
dollars) is $200,000 less than the value of those pounds when the loan was
obtained, and that the taxpayer still owns the factory at the time he repays
the loan. It is apparent that the taxpayer in the above example has not
realized any gain or loss with respect to his ownership of the factory because
he has not made any taxable disposition of his property. On the other hand, the
taxpayer has realized an economic gain of $200,000 on his loan transaction
because of the decline in the value of the foreign currency he borrowed between
the date the loan was made and the date the loan was repaid.
Similarly, in the instant case, because
taxpayers' sale of their residence is a separate transaction from the loan they
obtained to purchase the residence, taxpayers must account for each transaction
separately. As shown above, taxpayers realized *23 a gain on the sale of their
residence that was attributable in part to the appreciation in value of the
property and in part to the appreciation in the value of the pound (measured
against the dollar) between the date they purchased the property and the date
they sold it. Although the increase in the value of the pound caused taxpayers
to incur a loss on their separate loan transaction, that loss, as explained
above, is not deductible because Congress, with certain exceptions not
applicable here, has barred the deduction by individuals of losses not incurred
in a trade or business or a transaction entered into for profit. See I.R.C. §
165(c).
At bottom, the "harsh" result of
which taxpayers complain in the present case is entirely a function of
Congress's decision to tax income from whatever source derived (see I.R.C. §
61), but generally to disallow deductions for losses incurred in personal
transactions. [FN5] Because any unfairness in the result in this case is
attributable to the statutory scheme enacted by the Congress, any adjustment in
the applicable tax consequences can only come from the Congress.
FN5.
Thus, gain realized on the sale of a personal residence is includible in the
taxpayer's income but a loss incurred on the sale of a home is not deductible.
*24 CONCLUSION
For the foregoing reasons, the judgment of
the district court should be affirmed.
Appendix not available.