The ownership of real property is often made possible with mortgage and other debt financing. Such mortgage financing offers a US taxpayer the ability to deduct for income tax purposes the interest paid, subject to some limitations.
The repayment of the mortgage would not normally be expected to create an income tax liability. However, for a US citizen or resident repaying a non US-currency denominated debt or mortgage during a period of a strengthening US dollar vis-à-vis the currency of the foreign denominated mortgage, a gain may be realized in the eyes of the Internal Revenue Service.
In essence, where the amount of the mortgage repayment, when computed in US currency is less than the original amount of the mortgage when computed in US currency, a “gain” is realized. Consider the following example.
Bob, a US citizen living in Canada bought his Canadian home in 2010. He financed the purchase with a mortgage in the amount of $300,000 when the Canada-US exchange rate was at par. In 2014, Bob makes a lump-sum repayment of $100,000 on his mortgage at a time when the US dollar has appreciated 10% relative to the Canadian dollar (US$1 buys CDN$1.10).
In Canadian currency, CDN$100,000 has been used to repay CDN$100,000 of mortgage debt. However, from a US tax point of view, the extinguishment of CDN$100,000 of debt only costs Bob approximately US$91,000, yielding a perceived benefit of $9,000.
This “gain” would trigger a US liability potentially up to $4,000.
During a period of appreciation in the Canadian dollar relative to the US dollar, as we have recently experienced from 2010 through late 2013, there would be no “gain” realized on the repayment of a Canadian-dollar mortgage. However, the recent substantial strengthening of the US dollar globally will potentially mean an unexpected US tax liability for a US resident/citizen making a substantial debt repayment on a Canadian-dollar mortgage.
To add insult to injury, if you happen to repay your Canadian-dollar mortgage after selling your home for a loss, the personal loss on the sale of your home cannot be used to offset any gain realized on the repayment of the mortgage.
Before you rush to make that Canadian mortgage repayment, perhaps just give it a second thought so that there are no surprises the following spring when you file your US income tax return.
Written by Daren Raoux, CA, CPA