You establish a US dollar tax basis in the foreign currency when you open the account, as previously mentioned. Your tax basis is the USD value of the foreign currency at the time you purchase it (typically a spot rate convention is used). You will also have to report the income from the account in USD, and if you are cash method, you have income in dollars as it credited to your account, translated according to an acceptable method. So, for a foreign currency bank account that credits your account monthly with foreign currency interest, you'd have to translate the amount of FC received into USD when you receive it; it might be translated at an average rate for the monthly period, or at the spot rate on the date it is credited. You would have taxable income equal to this translated USD amount, and you would increase your tax basis in the account by the USD amount included in income (technically, the FC interest would take the specific USD basis and when you take out FC cash, you'd have to say which cash it is). It's not unlike keeping track of basis in fractional shares purchased through a dividend reinvestment plan. When you use or repatriate the cash, you will have foreign currency exchange gain or loss based on the difference between the current value of the currency relative to the US dollar at that time and your US dollar tax basis in the cash. This is ordinary income or loss, not capital gain or loss.
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