Today we will cover everything you need to know about converting foreign currency to USD on your U.S. expat tax return.
This is an essential point because your U.S. tax return obviously is prepared in U.S. dollars and most of the transactions that took place in your life while living in a foreign country, took place in a foreign currency (other than the U.S. dollar). These amounts will have to be translated from the local currency into the U.S. dollar. Let’s look into acceptable IRS currency conversion methods.
Types of currency exchange rates
We have several options to convert foreign currency to US dollars on your US tax return:
- The first one is the spot rate: the IRS does not disclose spot rates; you can use any reputable source on a consistent basis. For instance, when I deal with Canadian clients, I use the Bank of Canada’s exchange rates because that’s the rate that they have to use on their Canadian tax return. This way you can do a round trip translate from the Canadian dollar to the US dollar and back to the Canadian dollar and have the same number.
Any exchange rate from areputable source will be accepted by the IRS as long as it’s used on a consistent basis and not in a way to distort income.
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 second option is the average rate: For instance, if preparing a 2020 tax return, we would refer to a source that computed the average of all the daily exchange rates for 2020. The IRS does publish an average exchange rate (link) both for the current year and prior years. It’s not in any way legally binding; you can use any reliable source to get that.
- The third option is the year-end exchange rate, which is published by the Department of the Treasury. There are instances in which you have to use that one. The year-end exchange rate is simply the exchange rate on December 31st of any given year. For instance, for the tax year 2020, the year-end exchange rate would be the rate applicable on Dec 31, 2020.
Which exchange rate to use for various situations on your US tax return?
- FBAR and form 8938: It would be the year-end exchange rate. While we take the maximum bank account balance during the year, regardless of which day that balance was reached, it will be translated using the exchange rate on December 31st.
That exchange rate will be found on the Department of the Treasury‘s website. If the department of treasury does not cover the particular currency (which is unlikely), you can use any reputable source ; form 8938 will have a field for you to specify what that source is.
- Most income items on your tax return, including interest and dividend income: You actually have some flexibility between using the spot rate on the date of every transaction or the average rate, whichever method better reflects the situation.
In most cases, it’s very cumbersome to use the spot rate and in the end, the result will be very similar.
For instance, you can translate your wages using the spot rate of each paycheck. It will be cumbersome, and in the end, it would result in an amount close to simply translating the total using the average exchange rate.
On the other hand, if one single income transaction is material to your tax return, it might make more sense to use the exchange rate on the day of that transaction.
- Rental income: We’ll introduce the concept of QBU (Qualified Business Unit). A QBU is not necessarily a legal entity. In the case of the rental income, it would not be a legal entity but it is an activity for which you have a separate set of books; you’re doing your bookkeeping for that activity you have separate sets of books, you create an income statement for the activities separate from the rest of your income.
If you have a QBU, an activity for which you have a separate set of books you do its own bookkeeping, then you would first compute that income in the local currency and then translate it using the average exchange rate for the year.
- PFIC: If you own a PFIC within a brokerage account, it will likewise be a QBU; you would first compute that income in the local currency and then translate it using the average exchange rate for the year.
If you own a PFIC directly and not through a brokerage account then it’s probably not a QBU and you will translate the purchase price, sale price, and the spot rate of that transaction. You would translate the purchase price using the exchange rate on the day it was purchased and the sale price using the exchange rate on the day it was sold. The same would apply to most capital gain transactions as well.
- Foreign tax credits: We have two methods to claim the foreign tax credit
- 1) the paid method in which you look at everything you paid minus any refund you received from the foreign tax authorities. It’s cumbersome because you need to take into account every cash flow. Or,
- 2) you can use the accrual method in which normally you would simply look at the amount of tax owing for a year on your foreign tax return without any consideration as to whether it was paid before filing the return in the form of withholdings or paid after you submitted the foreign tax return with the check you send with the tax return.
When it comes to converting the foreign currency to USD to claim the foreign tax credit on your tax return, if you are using the paid method, you will be using the spot rate on the date of every payment. If you are using the accrual method, you will use the average exchange rate of the year.
As a side note, if you use the accrual method you cannot switch back to the paid method. So, if you use the accrual method you have to keep on using it every subsequent year which makes sense because again it’s the easier method to implement.
- Form 5471 has its own set of rules: Generally speaking, the average exchange rate is used but these rules are beyond the scope of this blog post.
The IRS official website has a list of government and external resources to determine currency exchange rates. Oanda.com along with some other options is a popular website to obtain historical rates. It is easy to navigate and find all the required information.