One challenge of reporting foreign assets and income on your U.S. tax return is determining which exchange rate should be used.
You must express the amounts you report on your U.S. tax return in U.S. dollars. If you receive all or part of your income or pay some or all of your expenses in foreign currency, you must translate the foreign currency into U.S. dollars.
How you do this depends on your functional currency. Your functional currency generally is the U.S. dollar unless you are required to use the currency of a foreign country.
Types of exchange rates
There are primarily three types of exchange rates:
A spot rate is the exchange rate on the day of the particular transaction. Spot rates are not provided by the IRS or the Treasury.
Treas. Reg. 1.988-1(d) states that you may use “exchange rates published in newspapers, financial journals or other daily financial news sources; or exchange rates quoted by electronic financial news services.”
The average rate is exactly what it sounds like – it’s the average exchange rate of a particular currency for the year. The IRS publishes both current and historical average exchange rates (link).
A year-end rates is the applicable exchange rates at the end of the calendar year. The U.S. Treasury publishes these rates for both current and previous years on its website (link).
Which rate to use for various situations
On the same tax return, you may be using different types of rates.
You must convert the maximum account value for each account into United States dollars using the Treasury year-end exchange rate.
If no Treasury Financial Management Service rate is available, use another verifiable exchange rate and provide the source of that rate (we’ve never come across this).
Interest income and dividend income
You can use a spot rate or the average rate, depending on which method better reflects the situation.
A rental property is generally considered a qualified business unit (QBU).
Income from a QBU must be first calculated in the functional currency (i.e., in the original currency) and then translated to USD using the average rate. This will capture any currency gain or loss.
To report a sale of a rental property, you must first calculate the gain/loss in the functional currency and then translate to USD using a weighted average exchange rate.
A brokerage account containing PFIC funds is likely going to be a QBU. Therefore, if a PFIC is disposed within a brokerage account, you’ll be required to calculate the gain/loss in foreign currency using the average exchange rate. You’ll use average exchange rates for distributions (e.g., dividends) and tax payments.
When a PFIC held directly (and not through a brokerage account) is sold, you’ll translate the cost basis to USD based on the spot rate on the date of purchase and the sales price based on the date of sale. Then gain/loss will calculated in USD. Dividends and tax payments are converted using the spot rate on the date of distribution.
Foreign tax credits
If claiming credit for foreign taxes using the paid method, you’ll use the date the foreign tax were paid (i.e., the spot rate).
If claiming credits using the accrued method, you’ll use the average exchange rate for the year in which the taxes were accrued.
When translating amounts from functional currency to U.S. dollars, you must use the method specified in the instructions. For example, when translating amounts to be reported on Schedule E, you generally must use the average exchange rate as defined in section 986(a).
Official and unofficial rates
Years ago we had an offshore compliance case that presented a unique predicament. The client was from Argentina, whose government had implemented strict currency controls, and which resulted in a black market exchange rate. In effect, the country had two exchange rates – one official and one unofficial. Although the government determined its official exchange rates, actual transactions were done using the black market rate which was widely published.
When we used the official rates, the client’s foreign company assets and income were drastically inflated, and did not reflect actual market conditions. So we researched and found that some recent court cases had allowed the taxpayer to use the official rate in these types of situations. And we did exactly that on the tax returns.
Since then the IRS has provided more guidance for these situations. Some countries where the IRS has stated it will consider unofficial rates include: Argentina, Egypt, Iran, Ukraine, and Venezuela. These countries have hyperinflation economies or have currency controls. This list is not exclusive.