The rules dealing with foreign currency are complex. Many of the rules are contained in section 988 of the Internal Revenue Code ("IRC") and in the 988 regulations.
Most U.S. individuals should treat foreign currency as though is it property and not as though it is money. IRC Sec. 988(c)(1)(C). Most U.S. individuals have the U.S. dollar as their "functional currency". IRC Sec. 985(b). Thus, when an individual buys or sells foreign currency it is as though he or she is buying or selling property. This summary does not consider taxpayers that have a qualified business unit (“QBU”). See Treas. Reg. § 1.989(a)-1(b). Note that individuals with portfolios of foreign currency denominated investments through foreign brokers may qualify as QBUs. See Treas. Reg. § 1.989(a)-1(e), Example (6).
As soon as one begins to think in terms of foreign currency being property, it must be understood that an "exchange" of property is taxable just like a sale of property. Thus, if someone "exchanges" foreign currency for stock or another asset, they will recognize a currency gain or loss.
For example, take $120 and convert it into 100 Euros (exchange rate of 1 Euro = $1.20). This is a purchase of property with a tax basis of $120. IRC Sec. 985(a). If the 100 Euros are immediately used to purchase an investment, then an exchange of property has occurred (foreign currency for stock). This exchange is a taxable transaction. Because the purchase of Euros was immediately followed by the purchase of stock, the currency gain or loss would be zero.
If the dollars were converted into Euros, but the purchase of the stock was delayed , then the purchase of the stock would trigger a currency gain or loss on the Euros (assuming exchange rates changed). In the example above, the US tax basis in the 100 Euros was $120. If the exchange rate is 1 Euro = $1.22 (Euro has appreciated) on the date of the stock purchase, then a gain would be triggered. Tax basis in the Euros is $120 and fair market value ("FMV") of the Euros is 122. Thus, a currency gain of $2 results.
Since the stock was acquired with Euros that had an FMV of $122, the US tax basis in the stock is $122.
When the stock is sold for Euros, another exchange has occurred (stock for Euros). This exchange will require the recognition of gain or loss. Continuing the example in the preceeding paragraph, the US tax basis in the stock was $122. If the stock is sold for 105 Euros and the exchange rate on the date of sale is 1 Euro = $1.24, then the value of the stock on the date of the sale was $130.20 (105 X 1.24). A gain of of $8.20 [130.2-122] must be recognized. This gain is not a currency gain, but is a gain on sale of stock.
The disposition of the stock was in exchange for 105 Euros. The US tax basis in these Euros is now $130.20. When these Euros are disposed of, another gain or loss calculation must be performed. Just about any type of disposition of the Euros will trigger gain or loss, including converting the Euros into US dollars.
Another topic to consider is the character of the gain or loss. Currency gains and losses of individuals when engaging in business or investment type activities are ordinary gains and losses. IRC Sec. 988(a)(1)(A) and 988(e). Currency gains of individuals engaging in personal activities are capital gains. There is an exception that exempts personal currency gains of less than $200. Currency losses of individuals engaging in personal activities are nondeductible personal expenditures. IRC Sec. 262.