Mortgage loan loss can't offset real estate gain on sale of U.K. home.

Mr. and Mrs. Quijano were U.S. taxpayers who sold their home in the United Kingdom. They purchased it in September 1986 for 297,500, pounds financing the entire amount with a mortgage, which two years later they increased to 330,000 pounds and, in March 1990, to 333,180 pounds. They made capital improvements of 45,647 pounds to the house, and, in July 1990, they sold it for 453,374 pounds--net of selling expenses--and retired the mortgage. On their 1990 joint federal income tax return, the Quijanos reported a capital gain of $308,811, using the exchange rate on the date of purchase ($1.49 to 1 pound) to determine their cost basis but using the exchange rate at the date of sale ($1.82 to 1 pound) to compute the sale price.

The couple later amended their 1990 return to claim a $30,610 refund. They arrived at the figure by using the exchange rate on the sale date to determine both the purchase and the sale price and to determine the cost of the capital improvements. This reduced the capital gain to $199,491. The Internal Revenue Service disallowed the amended refund claim, stating that the cost basis of the house had to be determined using the exchange rate on the purchase date and when each capital improvement was made.

The Quijanos argued that they suffered a loss on their mortgage loan transaction because the value of the dollar against the pound had declined between the time of purchase and the time of sale. They believed they should be allowed to offset this loss against the real estate transaction gain--the capital gain realized from the sale of the residence. The Quijanos argued the mortgage loan was part of a "hedging transaction" under Internal Revenue Code section 988(d)(1), so the loan transaction could be integrated with the real estate transaction. Under section: 988(d)(1), this treatment is allowed if the taxpayer is borrowing under a debt instrument where he or she, is obligated to repay the loan in a nonfunctional currency"

Result: For the IRS. The Tax Court rejected the Quijanos' argument that the transaction qualified as a hedging transaction because (1) the mortgage loan transaction was not conducted by a trade or business and was not entered into for profit and (2) the Tax Reform Act of 1986 explicitly excludes the use of section 988 for foreign currency gains or losses recognized by U.S. individuals residing outside the United States to repay a foreign-currency-denominated mortgage on a principal residence.

The Tax Court also rejected the Quijanos' use of the exchange rate in effect at the time of sale to determine the sale and purchase prices. The Quijanos wanted to treat the pound as their functional currency or qualified business unit (QBU) under IRC section 985(b)(1). However, the Tax Court found the taxpayers did not use the pound as the unit of trade or business for which they maintained separate books or records, so it did not qualify as a QBU. The court concluded that the basis, sale price and the cost of capital improvements had to be determined using the exchange rate in effect when the purchase, sale or improvement took place.

* Quijano (1st Cir. 1996).