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.