September 28th, 2022 Mary & Tim Johnson, American UK Tax Solutions
I. Is This the Ideal Time to Offload PFICs?
With the US dollar at historically high levels against the Pound Sterling and most other major currencies, worries abound about rising interest rates on mortgages, as well as dwindling values of Sterling denominated pensions and investments. It’s driving up inflation in the UK and elsewhere, as most energy prices are based on the US dollar. But, from a tax perspective, for Americans owning toxic investments known as Passive Foreign Investment Companies (PFICs), there may be a silver lining.
If you are one of 8.7 million Americans living abroad, or the many Americans living in the US, but who happen to own PFICs, this may be an opportunity to unload those assets from a purely tax perspective, as the strong dollar against most major currencies means that your gains on the sale of those assets would be significantly lower in most cases, than if you were selling those same investments when the dollar was weaker. Why? That is because the way that you calculate the gain or loss is based on the US dollar at the point of purchase and sale, regardless of the actual gain or loss calculated in the currency in which the transactions occurred.
The added complexity of dealing with PFICs is that unlike regular investments, gains would be taxed at higher PFIC specific or ordinary income vs the lower capital gains rates. Moreover, any PFIC gains can only be offset against losses on a PFIC specific basis for that particular PFIC fund, although only in certain circumstances. So, you would NOT be able to offset losses on one PFIC fund against another, nor against capital losses on current or prior year(s) carried over on your regular investment sales against the PFICs. There are additional caveats and special tax handling requirements for each PFIC depending on the type of election. Simply put, if you have PFICs, it is highly advisable to contact a US/UK dual tax specialist well versed in PFICs, especially now, when the US dollar is so strong against the Sterling. This may be the ideal time to slim down the number of your PFIC holdings, recognize any lossess, and reduce your overall tax filing costs in subsequent years, which, for many, can add up to thousands of Pounds.
II. Beware: Worst Time to Close/Remortgage
While a strong dollar tends to reduce gains on sales of foreign denominated investments, whose currency has weakened against the dollar, such as the Pound Sterling, the OPPOSITE is true when it comes to remortgaging. As in the case with PFICs, US taxes are calculated in US dollars at the point of purchase/sale in the case of investments, and at the point of opening or settling a mortgage, in the case of foreign denominated mortgages. So, you would need to take the US dollar equivalent using the daily exchange rates on the date of these transactions.
For example, let’s say that you took out a Pound Sterling denominated £500K mortgage on June 1st, 2000, had paid off £400K by the end 2001, and decided to pay off the remaining balance of £100K on September 1st, 2022. What would be the impact of this transaction on your US 2022 tax return?
I. Is This the Ideal Time to Offload PFICs?
With the US dollar at historically high levels against the Pound Sterling and most other major currencies, worries abound about rising interest rates on mortgages, as well as dwindling values of Sterling denominated pensions and investments. It’s driving up inflation in the UK and elsewhere, as most energy prices are based on the US dollar. But, from a tax perspective, for Americans owning toxic investments known as Passive Foreign Investment Companies (PFICs), there may be a silver lining.
If you are one of 8.7 million Americans living abroad, or the many Americans living in the US, but who happen to own PFICs, this may be an opportunity to unload those assets from a purely tax perspective, as the strong dollar against most major currencies means that your gains on the sale of those assets would be significantly lower in most cases, than if you were selling those same investments when the dollar was weaker. Why? That is because the way that you calculate the gain or loss is based on the US dollar at the point of purchase and sale, regardless of the actual gain or loss calculated in the currency in which the transactions occurred.
The added complexity of dealing with PFICs is that unlike regular investments, gains would be taxed at higher PFIC specific or ordinary income vs the lower capital gains rates. Moreover, any PFIC gains can only be offset against losses on a PFIC specific basis for that particular PFIC fund, although only in certain circumstances. So, you would NOT be able to offset losses on one PFIC fund against another, nor against capital losses on current or prior year(s) carried over on your regular investment sales against the PFICs. There are additional caveats and special tax handling requirements for each PFIC depending on the type of election. Simply put, if you have PFICs, it is highly advisable to contact a US/UK dual tax specialist well versed in PFICs, especially now, when the US dollar is so strong against the Sterling. This may be the ideal time to slim down the number of your PFIC holdings, recognize any lossess, and reduce your overall tax filing costs in subsequent years, which, for many, can add up to thousands of Pounds.
II. Beware: Worst Time to Close/Remortgage
While a strong dollar tends to reduce gains on sales of foreign denominated investments, whose currency has weakened against the dollar, such as the Pound Sterling, the OPPOSITE is true when it comes to remortgaging. As in the case with PFICs, US taxes are calculated in US dollars at the point of purchase/sale in the case of investments, and at the point of opening or settling a mortgage, in the case of foreign denominated mortgages. So, you would need to take the US dollar equivalent using the daily exchange rates on the date of these transactions.
For example, let’s say that you took out a Pound Sterling denominated £500K mortgage on June 1st, 2000, had paid off £400K by the end 2001, and decided to pay off the remaining balance of £100K on September 1st, 2022. What would be the impact of this transaction on your US 2022 tax return?
- The only number that matters is the £100K balance in terms of calculations.
- The £100K on June 1st, 2000 would have been equal to USD149K as the daily exchange rate for that date was 1.4928 USD/1 Pound Sterling.
- The £100K on September 20th, 2022 would be the equivalent of USD114K as the daily exchange rate for that was 1.1415 USD/1 Pound Sterling.
- The foreign exchange rate gain, would work out to a GAIN of USD35K, on which you would have to pay US federal taxes, at ordinary tax rates (higher than capital gains rates for investments).
- In real terms, from the perspective someone living and earning in the UK there was no actual gain. You borrowed £100k and repaid £100k. HOWEVER, from a US federal tax perspective, there is a taxable GAIN, as the numbers would first have needed to be converted to US dollar equivalents on the relevant transaction dates.
One caveat – everything is relative. The key reference points are when you originally took out the mortgage/remortgaged versus when you closed it out. (Note that a remortgage is often treated as settling the old mortgage, and starting a new one.) If you look at the graph below, the bigger the spread between the GBP/USD value of your ‘start date’ and the ‘end date’ – the bigger your foreign exchange ‘gain.’ As you can see, July 2014 was when the Pound was at its 10 year high against the dollar at around 1.71602 USD/GBP. Those who took out their mortgages around then, will have a bigger gain than those, who took out their loans in February/March 2020, when the USD/GBP was lower – assuming they were to close out now (September 2022).
However, even if the difference in exchange rate was less, depending on the size of your mortgage, it could still result in a sizeable ordinary gain for US tax purposes. So, you may want to think very carefully BEFORE repaying or remortgaging a non-US Dollar denominated mortgage, particularly one based on the Pound, which is at historical lows. While rising mortgage interest rates may make it tempting to remortgage or pay off that mortgage, as an American or US Green Card holder, you should offset any potential projected gains, against a hefty foreign exchange gain from a US tax perspective.
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