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Own Foreign Property? Beware of Phantom Gains

Foreign Property
Foreign property ownership can be a rewarding and lucrative experience for many Americans living overseas. But when it comes time to sell your foreign property, you may be in for a scary surprise. In addition to paying local taxes on property sales, you may be on the hook for US taxes on phantom gains—a hidden source of taxable income that can gobble up profits from your foreign property investment.

What Are Phantom Gains?

Phantom gains occur when you owe capital gains tax on an investment, even though you didn’t earn a tangible return. Why does this happen? In the case of foreign property owners, phantom gains are caused by changes in currency exchange rates.


How Phantom Gains Affect Foreign Property Sales

Before you can calculate the taxable capital gains from a foreign property sale, you need to convert the cost basis and sales price to USD. To do this, you’ll use the exchange rate from the date that each transaction occurred. As a result, exchange rate fluctuations can create a phantom gain or loss that didn’t appear when capital gains were calculated in the local currency.

For example, if you purchased a home in Germany in December 2016 for 500,000 Euros and sold it in December 2019 for 500,000 Euros, it would appear that you have not earned a capital gain. However, due to currency exchange rates, you will show a gain of 34,927.36 USD.

Exchange Rates:

  • December 31, 2016: 0.9490 Euros per $1 USD
  • December 31, 2019: 8900 Euros per $1 USD

Purchase Price in USD on December 31, 2016:

  • 500,000 Euros ÷ 0.9490 Euros/USD = 526,870.39 USD

Sale Price in USD on December 31, 2019:

  • 500,000 Euros ÷ 0.8900 Euros/USD = 561,797.75 USD

Capital Gain in USD:

  • 561,797.75 USD – 526,870.39 USD = 34,927.36 USD

If the property is your primary residence and you lived in the home for at least two of the past five years, you can exclude gains up to $250,000 ($500,000 for married couples). In the example above, you can use this exclusion to eliminate capital gains taxes completely.

If the property was not your primary residence, you will owe taxes on the phantom capital gains. Fortunately, expats can use foreign tax credits to offset their US taxes. Alternatively, if you experience a phantom loss, no US taxes are due and you will not be allowed to deduct the loss.


Considering Refinancing? Look Out for Phantom Gains

When a mortgage is paid off—either at the time property is sold or during refinancing—capital gains from currency exchange are subject to US taxation. This is calculated similarly to capital gains from property sales.

Using the exchange rates from our example above, here is how the capital gain/loss would be calculated if the foreign property owner had 350,000 Euros left to pay on the mortgage:

Remaining Mortgage: 350,000 Euros

Mortgage Purchase:

  • 350,000 Euros ÷ 0.9490 Euros/USD = 368,809.27 USD

Mortgage Payoff:

  • 350,000 Euros ÷ 0.8900 Euros/USD = 393,258.43 USD

Capital Loss in USD:

  • 368,809.27 USD – 393,258.43 USD = (24,449.16 USD)

Capital losses from a mortgage payoff are not deductible. Capital gains, on the other hand, are taxed at ordinary income rates.


Don’t Get Spooked by Phantom Gains

Thinking about buying or selling foreign property? Remember to check the current exchange rates to determine how phantom gains will impact your US taxes. While you can’t control the effects of currency exchange, you can plan for the financial consequences—and possibly avoid a larger tax bill by adjusting your sale or purchase date slightly. Accountants who specialize in taxes for Americans living abroad can help you navigate these complexities to make the best decision for your wallet and lifestyle.