Exchange Rate to use for Foreign Income, 8938 & FBAR?
Exchange Rate for Foreign Income: When a taxpayer has to file a US tax return or international information return, and include foreign income or account/asset information (which is maintained in foreign currency) — they must translate or exchange the foreign currency into US currency. But, which exchange rate do Taxpayers use?
Some IRS forms require the taxpayer to include both the foreign “functional currency” along with that same currency translated into US dollars — such as the Form 5471. In general, the IRS does not require any one specific exchange rate to be used — but there are guidelines to abide by (note: some tax forms do have very specific requirements for exchange rates).
Let’s review the basics of IRS exchange rates and foreign income, foreign accounts and assets.
What does the IRS Require for Foreign Exchange Rates?
There is no one specific exchange rate that a Taxpayer must use.
As provided by the IRS:
Translating Foreign Currency
“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…”
Make all income tax determinations in your functional currency.
If your functional currency is the U.S. dollar, you must immediately translate into dollars all items of income, expense, etc. (including taxes), that you receive, pay, or accrue in a foreign currency and that will affect computation of your income tax. Use the exchange rate prevailing when you receive, pay, or accrue the item. If there is more than one exchange rate, use the one that most properly reflects your income. You can generally get exchange rates from banks and U.S. Embassies.
If your functional currency is not the U.S. dollar, make all income tax determinations in your functional currency. At the end of the year, translate the results, such as income or loss, into U.S. dollars to report on your income tax return.
What does this Mean?
It means you must use a prevailing a reasonable exchange rate when you translate foreign dollars in to U.S. dollars, unless you have a QBU.
Exchange Rate vs. What You Can Actually Exchange it For
Just because a U.S. exchange rate provides for a specific daily, quarterly, or average annual exchange rate for foreign currency does not mean the person can actually obtain that exchange rate in the foreign country.
This is common in countries such as Iran — where black market exchanges occur.
For example, if you are in Iran and you want to exchange Iranian Rials into US income, The US exchange rate is 42,000 rial: 1 U.S. Dollar.
Does that mean if you are in Iran and exchanging that money into US dollars — you will actually get that exchange rate? No, you generally lose significant value when trying to perform the exchange and get the money out of the country.
In order to avoid unnecessary scrutiny, experienced tax practitioners always recommend relying on the IRS or DOT exchange rate (unless it involves spot rate).
No Specific IRS Exchange Rate for Foreign Income is Required
There is not one required IRS exchange rate that you have to use.
Rather, the IRS requires the taxpayer to use an “acceptable” exchange rate — but what does that mean?
It means you can choose an exchange rate such as the Department of Treasury, Internal Revenue Service average rates, X-Rate, and OANDA.
The goal is to keep it consistent.
For example, if you are using the Department of Treasury exchange rates in your tax return for 2020, then you should consistently use that same exchange rate throughout the return — absent spot rates for gains.
IRS Exchange Rate vs Department of Treasury
Two of the most common exchange rates people use is the average exchange rate from the Internal Revenue Service and the Department of Exchange rates (published quarterly).
While not one specific exchange rate is preferred over the other, most practitioners prefer the Department of Treasury exchange rates to reduce IRS scrutiny.
For example, on the form 8938 — which is a very common international reporting form — it includes the following statement: “Source of exchange rate used if not from U.S. Treasury Department’s Bureau of the Fiscal Service.”
In order to minimize scrutiny, Taxpayers should consider using the Department of Treasury exchange rates.
Which Tax Year Date is Used?
Which exchange rate a person uses may change depending on what type of income, assets or accounts they are reporting. One of the more complicated calculations is capital gains.
Foreign Capital Gain Sales
When it comes to capital gains sales, the rules are applied a bit different.
Generally the transaction involves two spot rates.
Let’s take an example: if a person purchased a property on January 1st 2010, and sold the property on December 8th 2020, the taxpayer will refer specifically to those two exchange rates to determine which exchange rate should be used for each day.
Unlike interest income, the capital gain is a single event (excluding capital gain distributions) and therefore the specific exchange rates for each event (e.g., purchase and sale) are used.
Accounts or Assets & IRS Exchange Rates for Foreign Income
Typically, most practitioners will refer to the Department of Treasury exchange rates when it comes to reporting foreign accounts, assets, and investments. And, to keep things relatively simple and straightforward they will use the year-end exchange rates.
Some practitioners opt to use specific spot rates based on various factors — but this is generally not necessary.
In one example, we took over for a less experienced attorney who misunderstood spot rates and had used different spot rates for dividend and interest distributions based on the day the spot rates hit the account.
The practitioner was sure this was the way to do it (and a bit acerbic about it, since they “used to work for the IRS” as an agent or examiner).
When we took over and spoke with the IRS agent assigned to the case, his first question was “why not just use the year-end rates?”
He then asked us to go back and exchange all of the income into the same year-end rate.
So there you have it.
Be Consistent with IRS Exchange Rates for Foreign Income
As with anything in life, the key to success is being consistent. The same holds true with IRS exchange rate analysis for tax returns and international information returns.
You should rely on exchange rates that are accepted such as the IRS and DOT — unless you are using a spot rate, and then OANDA (if an applicable year) may be your best bet.
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