Do I have US phantom gains when settling my UK mortgage?
Published on February 12, 2024
by Rose-ann De Villa, EA, CPA
Rose-ann De Villa, an IRS Enrolled Agent and CPA with 12 years of expat tax experience, specializes in U.S. tax preparation, tax planning, and tax advice for U.S. citizens and Green Card holders living and working in the UK.
Rose-ann has also talked about starting a business in the UK as a U.S. expat
Rose-ann has been mentioned in the Daily Express UK news wherein she talked about Stimulus payments and Child Tax Credit refunds for U.S. expats in the UK.
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If the foreign currency has weakened in the time between taking out a mortgage (borrowing money) and when you pay off your mortgage (or remortgage), you could have made a phantom gain, or what the US tax industry calls a foreign mortgage gain.
So, generally, phantom gains occur under these circumstances:
- Foreign Currency Mortgage: The scenario typically involves a US citizen having a mortgage in a foreign country (like the UK) with the loan denominated in a non-US dollar currency (British pounds in this case).
- Refinancing or Selling Property: Phantom gains can be realized when you renegotiate your mortgage rate with your bank or when you settle your mortgage completely, usually when a property is sold.
What’s a common situation I can use as a reference?
Consider a US citizen living in the UK who decides to refinance or sell their property. The mortgage is in British pounds with a UK bank.
If the exchange rate between the pound and the US dollar changes significantly (e.g., the pound weakens), it can create a situation where the amount in US dollars required to settle the loan is less than when it was initially borrowed.
This means, on paper at least, you’re repaying less US dollars than you borrowed. This looks like you’ve gained the difference and put it in your pocket.
In reality, of course, you haven’t made a gain—but the ‘phantom’ gain is still taxable income on your US tax return.
How does this impact my US tax return?
Exchange Rate Variance: The key factor is the change in the exchange rate between the time the loan was taken out and when it was settled. This variance can result in a taxable gain, even though in practical terms, you’re just paying off the loan with the same amount of pounds.
Taxpayer Awareness: Many US taxpayers are not aware of this tax implication. It’s crucial to understand that even if you’re just settling a loan with the same amount of foreign currency, the exchange rate difference can create a taxable event in the US.
Phantom gains are an important consideration for US expats dealing with property and mortgages in foreign currencies, which is why consulting with a tax professional can help avoid complex scenarios and ensure compliance with US tax obligations.
I want to know more about US taxes abroad
What is a phantom gain on a mortgage settlement?
Let’s take a look at a scenario: A US citizen bought a property in the UK for £100,000, equivalent to around US$140,000 at the time of purchase. Due to exchange rate changes, when repaying the mortgage, the same £100,000 translated to US$100,000.
To the IRS, it looks like you borrowed US$140,000 and only paid back US$100,000—you’ve gained $40,000.
How does the IRS view this? The IRS views the US$40,000 difference as income, even though it’s not actual money received by the taxpayer. This is where the term “phantom gain” comes into play.
The US$40,000 US dollars is treated as ordinary income, not as a capital gain. This means it’s subject to ordinary tax rates, which can be as high as 37%.
Additionally, this income cannot be offset by capital losses and is not eligible for the foreign earned income exclusion, as it’s not considered earned income.
So, what can I do to mitigate this?
- Utilize Foreign Tax Credits: If there are foreign tax credit carryovers in the general basket from past tax returns, these can be used to at least partially cover the US tax on this ordinary income.
- Amend Tax Returns: Taxpayers can amend their returns going back as far as three years. However, this process is subject to IRS scrutiny, especially when changing elections to optimize tax benefits.
Phantom gains represent a complex tax issue for US expats involving real estate transactions in foreign currencies. It’s crucial to understand these implications and plan accordingly. Consulting with a tax professional can provide valuable insights and strategies to manage these unique tax situations effectively.
What happens if I experience phantom losses?
What happens when, instead of gaining, you lose US$40,000 dollars due to exchange rate fluctuations on a foreign mortgage or property sale?
Unfortunately, the IRS does not recognize this US$40,000 dollars in the same way it would a phantom gain. This means the taxpayer cannot use this loss to offset other income on their US tax return.
How does the IRS handle phantom losses?
The IRS tends to recognize and tax phantom gains but does not offer relief for phantom losses. This can lead to a situation where taxpayers are liable for taxes on gains they never actually realized in cash.
Does this mean I’m taxed highly if I have phantom gains?
It depends. If previous tax returns were not optimized to accumulate foreign tax credits, taxpayers might find themselves without any FTCs to offset the tax due on phantom gains.
Additionally, for high-income earners, this can result in substantial tax liabilities, potentially as high as 37% of the phantom gain, plus an additional 3.8% for the net investment income tax.
Phantom gains and losses present unique challenges for US expats, particularly in the context of foreign currency fluctuations. The IRS’s approach to these transactions can lead to significant tax implications, especially when phantom losses are not recognized for tax relief.
It’s crucial for US expats to be aware of these rules and to seek professional tax advice to make informed decisions and potentially mitigate tax liabilities.
How do I check if I have phantom gains?
To determine if you have a phantom gain, you need to know the exact dates when you took out and paid off your loan or mortgage. The key is to check the exchange rates on these specific dates.
Compare the US dollar amounts at the time of borrowing and repayment. A phantom gain occurs if you end up paying back less in US dollars than what you initially borrowed, due to favorable exchange rate movements.
Google the exchange rate on the day you borrowed the money and see the total in US dollars.
Next, Google the exchange rate on the day you settled or paid off your mortgage and see what the amount was in US dollars.
If you paid back less than you borrowed, you likely have a phantom gain.
This simple calculation doesn’t take into account monthly repayments made on your mortgage and it doesn’t take into account paying down the principal amount.
Another consideration is when your fixed-term mortgage comes to an end and you take a new deal with your bank or lender. Each time a new deal is entered into a phantom gain could have occurred.
Always have a US tax professional check the calculations for you.
What do I do if I suspect a phantom gain?
The best course of action is to consult with a US tax professional. They can assess your specific situation and help you understand the implications of your US tax return.
A tax expert can guide you through strategies to potentially mitigate your US tax exposure resulting from the phantom gain. This might involve exploring various tax credits or deductions you may be eligible for.
Phantom gains can significantly impact your US tax obligations, especially if you’ve been involved in foreign property transactions.
By understanding how to calculate these gains and seeking professional advice, you can better navigate the complexities of US tax law as an expat. Proactive steps and expert guidance are key to managing your tax responsibilities responsibly.
