Anyone who has asked me knows I am no fan of investing in real estate in (Western) Europe at the moment. One of the biggest risks I see (aside from the fact that real estate prices have not “corrected” yet in many cities) is a little-known IRS law concerning taking out a mortgage in foreign currency.

Sec. 985(a) of the Internal Revenue Code generally requires all income tax determinations to be made in the taxpayer’s “Functional Currency”, which for US citizens and greencard holders is always the USD, regardless of where they reside or how they are paid. Sec. 988 of the Code covers “988 transaction”, which includes the acquisition of debt in a non-functional currency such as becoming an obligor under a mortgage, and requires you to use your functional currency when determining a gain or loss on the mortgage.

What does this actually mean for you? It means that you need to convert the amount of the loan into USD at the time you borrow the money and again at the time you pay off the loan. If there is a gain, this is taxable as ordinary income (not capital gain and not eligible for the $250K/$500K exclusion under IRC Sec. 121). If you have a loss, this is considered a “personal”, non-deductible loss (so basically the IRS gets the upside but not the downside).

This hasn’t been much of an issue for the past several years, because the weakening dollar has created losses, which are not deductible. Also, most taxpayers didn’t even know they had a loss (because this law is pretty obscure) so they didn’t feel like they missed out. In addition, rising home prices have created gains (in both Euro and dollar terms) on most sales, so everyone’s happy.

So why is this a dangerous time to take out a foreign mortgage? I can’t predict the future, but my money is on the dollar strengthening over the next few years. If this happens, you will start to see the ugly side of this law. For example, if you borrowed EUR 1M today, you would be borrowing approx. $1,550,000. Now assume you pay off this mortgage 10 years from now, and the dollar has strengthened significantly, back to 1:1 with the Euro (hey, it could happen!). This means you only need to pay back $1,000,000 (in the eyes of the IRS). In this case you have a $550,000 gain from paying off your foreign mortgage, taxable as ordinary income, so as high as 35% (or whatever higher rate may be in place at the time). This means a potential tax of almost $200K, even if you actually lost money on the home sale, which I think is a “real” risk at the moment.

Sound too bad to be true? These rules are clearly laid out in Rev. Ruling 90-79, 1990-2 CB 187, and also in the 1996 court case “Quijano v. the United States” (96-2 USTC P 50,441), and don’t leave much room for interpretation.

I’m not a fan of letting taxes rule your “life” decisions, but this one is definitely something to take into account if you are currently considering buying a property in Europe and don’t have the cash to purchase without a mortgage.