What Are FX Gains? Calculation and Tax Implications
Timing differences in foreign currency conversions can create taxable gains, which are treated differently for business operations and personal investments.
A foreign exchange (FX) gain is a profit realized from a change in one currency’s value relative to another. When you hold a foreign currency or an asset denominated in one, its value can fluctuate when measured in your home currency. An FX gain occurs if the foreign currency’s value increases compared to your home currency between its acquisition and disposal.
For example, a U.S. resident might buy a souvenir in Europe for €100 when the exchange rate is $1.10 per euro, costing $110. If the rate later moves to $1.15 per euro, that same €100 is now worth $115, and the $5 difference represents an FX gain. This principle applies to many international transactions for individuals and businesses.
Core Concepts of Currency Exchange
The exchange rate is the value of one currency for its conversion to another, and these rates fluctuate constantly based on various economic and geopolitical factors. For U.S. individuals and businesses, these fluctuations are measured against their functional currency, which is almost always the U.S. dollar. All transactions in other currencies must be translated back into the functional currency to determine profit, loss, and tax obligations.
The timing of a transaction creates the potential for a gain or loss. A distinction exists between the transaction date, when an obligation is created, and the settlement date, when payment is made and currency is converted. The exchange rate can change between these two dates, creating the conditions for an FX gain or loss.
Identifying and Calculating FX Gains
A distinction must be made between unrealized and realized gains. An unrealized gain is a potential profit that exists on paper, such as holding money in a foreign bank account while the foreign currency strengthens against the dollar. This gain becomes realized only when you convert the foreign currency back into your functional currency.
Calculating a realized gain for a business is a direct process. Consider a U.S. software company that licenses its product to a German client for €50,000. On the invoice date (the transaction date), the exchange rate is $1.08 per euro, and the company records accounts receivable of $54,000.
Thirty days later, when the client pays on the settlement date, the exchange rate has moved to $1.11 per euro. Upon receiving the €50,000 payment, the company converts it to U.S. dollars, receiving $55,500. The company has a realized FX gain of $1,500 ($55,500 – $54,000), which must be recognized as income.
Individuals encounter FX gains most often through investments. Imagine an investor in the U.S. buys 100 shares of a company on the London Stock Exchange for a total of £3,000. On the purchase date, the exchange rate is $1.25 per British pound, making the investment’s cost basis $3,750.
A year later, the investor sells all 100 shares for £3,500. On the sale date, the exchange rate has strengthened to $1.30 per pound, making the proceeds in U.S. dollars $4,550. The total gain is $800 ($4,550 – $3,750), which includes both the gain from the stock’s appreciation and the gain from currency movement.
Tax Consequences of FX Gains
The U.S. tax system treats realized foreign exchange gains as taxable income. Only gains realized through the conversion of foreign currency or the settlement of a transaction are subject to tax. Unrealized gains from simply holding a foreign currency or asset do not trigger a tax event.
For most foreign currency transactions, the resulting gains or losses are governed by Section 988 of the Internal Revenue Code. The default rule under this section is that FX gains and losses are treated as ordinary income or loss, rather than capital gain or loss. This applies to a wide range of transactions by both businesses and individuals.
For businesses, this treatment is straightforward. FX gains related to normal business operations, such as sales to foreign customers, are considered ordinary income and taxed at the company’s standard corporate tax rate. The $1,500 FX gain from the earlier example would be added to the company’s other ordinary income.
For individuals, the tax consequences can be more complex with investments. When an individual sells a foreign asset like a stock, the gain must be split into two parts. The portion of the gain from the asset’s price increase in its own currency is a capital gain. The portion from the favorable movement of the exchange rate is generally treated as ordinary income, which also applies to gains from holding foreign currency in a bank account.