Tax impact on hedging a foreign currency mortgage

[MarkLondon]

I'm a US taxpayer living in the UK with a home mortgage denominated in Pounds Sterling.  Due to the recent drop in the Pound, I have a significant taxable gain in the mortgage.  I don't want to payoff my mortgage since the interest rate is fixed for another couple of years and is quite low.  When the fixed period ends, I'll likely need to refinance the mortgage at which time I would need to recognize the FX gain or loss on the mortgage for US tax purposes.

I'd like to lock in the FX gain by doing an FX forward contract.  I know any FX gain on the mortgage when I refinance will be treated as ordinary income and any FX loss would be a personal loss.  But how will the gain/loss on the FX forward contract be treated from a US tax perspective?  Will that gain/loss only be recognized when I close the forward contract?  How is the gain/loss from the forward contract treated for US tax purposes?

[Anonymous_]

@pk

[pk]

@MarkLondon As I understand the situation:

(a) You a US person ( citizen / Green Card ) is living in the UK 

(b) you have local mortgage -- on a residence ( home ) -- through a local lender. Thus it is UKL denominated.  So for US tax purposes, and only if you itemize , there is a lowering of interest payments but this is not a gain in any sense -- it is less of a deduction.

(c) your mortgage interest rate is likely to change in the future  and you would like to find ways to offset this  through forward contracts  ( as a hedge ? )

(d) the hedge contract  is a thing in its own right  and has nothing to do with the mortgage and deduction thereof.   You will have to recognize any gain / loss on consummation/ quenching  of the contract .

So I am at a loss to understand where you get a FX gain/loss on the mortgage  contract -- it is the deduction  that is affected by the exchange rate and the interest rate in US$.

The FX contract is an investment and is recognized as such  , even though it may indeed help your overall balance sheet.

Am I in the left field ?

Is there more I can do for you ?

[MarkLondon]

See section 988.  I borrowed at one exchange rate and will repay/refinance at another.  The difference between the US dollar value of the loan at inception and the usd value of the loan at repayment or refinance is a fx gain or loss under 988.

[pk]

@MarkLondon , yes I have gone through section 988 and related areas.  My opinion still is  (a) you are taking on a debt not a debt instrument, this is your residence and not an investment ( it may work out to be ),  for US tax purposes  your functional currency is  UKL ( and converted to  US$ for recognition purposes).  There is not gain in your functional currency by reducing your  deductions for US tax purposes.  In my view  how is this any different from  your original home loan at  say 5% and  later say refinanced at  3% in the USA ---- none.  If I assume that your functional currency  is  your tax home currency, then again a similar situation would produce no taxable income ( because it is deduction only under  USA mortgage interest deduction.).  

Of course , if you do disagree  and  actually recognize the FX gain and pay taxes on this per section 988 and follow-on sections, IRS would be too happy without question.

On the forward hedging contract , it is different matter  and  yes section 988 recognition should apply.

It is your choice but my humble opinion to take the simplest interpretation  still stand. 

pk