Currency Fluctuations and Phantom Gains

US citizens living overseas must use the US dollar as their functional currency. The volatility in currency exchange rates can cause taxable events for US citizens trying to do normal life transactions and when filing their US taxes.

Currency fluctuations are especially problematic for mortgages. Phantom gains on debt forgiveness if the USD appreciates over the term of the mortgage can be virtually impossible for everyday taxpayers to keep track of. Most US citizens overseas are not trying to speculate on currency, and most are working in their local jurisdiction currency.  To complicate the situation phantom gains are taxable however, phantom loses cannot be taken as a tax credit.

If a US citizen overseas buys a house in Europe with a €1 million mortgage while the exchange rate is €1:$1, the expat will also have a $1 million mortgage. If the USD strengthens over time and, over the course of the mortgage, €1 million euros is the same as $900,000, the IRS will say there is $100,000 of debt forgiveness income (the original $1 million minus the $900,000 principal paid). This will result in a large, unexpected tax bill at their ordinary tax rate that is not eligible for foreign tax credit relief. Also, had the dollar weakened against the euro, the resulting loss (paying more than $1 million in principle) would not be allowed.