Missed US Tax Returns: Form 8886 and Sterling Currency Losses

Americans in the UK who are catching up on missed US tax returns must attach Form 8886 to any return that claims a section 988 foreign currency loss of $50,000 or more in a single tax year. No tax shelter is needed to trigger the rule, and omitting the form carries its own penalty.

That threshold surprises most people who meet it. The reportable-transaction regime was written to expose engineered tax shelters, and its general loss threshold for individuals sits at $2 million in a single year. Currency losses are the exception. For an individual, a section 988 loss is tested against a figure forty times lower, and for anyone holding seven-figure sterling balances, sterling loans or currency forwards, an ordinary year of exchange-rate movement can cross it. At Jungle Tax we prepare US and UK returns for Americans living in Britain, and this is one of the disclosure forms we most often find missing from returns prepared without cross-border experience. This guide explains when the form is required, how the loss is measured, what the penalty is, and how a missed Form 8886 is put right on late, amended and streamlined filings.

What is Form 8886 and why does it apply to a currency loss?

Form 8886, the Reportable Transaction Disclosure Statement, is the form a taxpayer uses to tell the IRS that a return reflects a transaction falling within one of the reportable categories in Treasury Regulation section 1.6011-4. Those categories are listed transactions, confidential transactions, transactions with contractual protection, transactions of interest and loss transactions. Only the last one matters here.

A loss transaction is any transaction that results in the taxpayer claiming a loss under section 165 of the Internal Revenue Code at or above a set threshold. The IRS instructions for Form 8886 set the thresholds for individuals as follows:

• at least $2 million in any single tax year, or $4 million in any combination of tax years, for losses generally; and
• at least $50,000 in any single tax year where the loss arises from a section 988 transaction, whether or not the loss flows through from a partnership or S corporation.

The rule is purely mechanical. It does not ask whether the transaction had a tax motive, whether an adviser promoted it, or whether the loss is legitimate. A perfectly genuine exchange loss on a sterling deposit is reportable if it is claimed on the return and meets the threshold. The form is a disclosure, not an admission, and filing it does not by itself change the tax due.

What counts as a section 988 loss for an American living in the UK?

Every US citizen and green card holder computes US tax in US dollars, wherever they live. For an individual the dollar is the functional currency, which makes sterling a nonfunctional currency even for someone who earns, spends and saves entirely in pounds. Section 988 treats exchange gain or loss on specified transactions in a nonfunctional currency as ordinary income or ordinary loss, calculated separately from any gain or loss on the underlying asset.

For a UK resident American the transactions most often caught are these.

Sterling cash and deposits

Sterling is treated as property for US purposes. Each pound has a dollar basis fixed by the exchange rate on the day it was acquired, and disposing of it, by spending it, converting it to dollars or using it to buy an investment, is a realisation event. Where sterling was acquired at a strong rate and disposed of at a weaker one, the difference is an exchange loss. Large balances built up from a property sale, a business sale or accumulated bonuses can produce substantial figures on a single conversion.

Sterling loans, as lender or as borrower

A debt denominated in sterling is a section 988 transaction on both sides. A lender who is repaid in pounds worth fewer dollars than the pounds advanced has an exchange loss on the principal. A borrower who repays a sterling loan after the pound has strengthened has to find more dollars to clear the same sterling balance, and that is also an exchange loss. Loans to and from a person's own company, private loan notes and shareholder loan accounts all fall within this, as do mortgages.

Forward contracts and similar instruments

Forward contracts, currency swaps and options over sterling are section 988 transactions when entered into by a dollar-functional taxpayer. Individuals often use forwards to fix the rate on a known future payment such as a property completion or a tax bill. A forward that settles out of the money produces an exchange loss, and a single large contract can exceed $50,000 on its own.

Sterling-denominated bonds and receivables

Holding a sterling debt instrument, or having the right to receive a sterling sum such as deferred sale consideration, also falls within section 988. The currency element of the result is separated from any market gain or loss on the instrument and treated as ordinary.

Does the personal-transaction exception remove the problem?

Partly, and understanding why is central to preparing these returns correctly. Section 988(e) contains a rule for personal transactions, meaning those not connected with a trade or business or with investment activity. Under it, exchange gain on a personal transaction is disregarded where the gain on that transaction does not exceed $200. That is a relief for small gains on everyday spending. It says nothing favourable about losses.

Losses are governed by section 165(c), which allows an individual to deduct a loss only if it arises in a trade or business, in a transaction entered into for profit, or from a casualty or theft. An exchange loss on a purely personal transaction is therefore not deductible at all. The classic example is the mortgage on a main home: an American who repays a sterling mortgage after the pound has strengthened has a real economic loss in dollar terms, but because the borrowing was personal the loss cannot be claimed.

This matters for Form 8886 because a loss transaction is defined by reference to a loss the taxpayer claims. Where the loss is personal and correctly left off the return, no section 165 loss is claimed and no disclosure is triggered. The practical position is as follows.

• A sterling current account used for household spending produces personal exchange losses that are not deductible and not reportable.
• A sterling deposit, loan or forward held for investment or business reasons produces an ordinary loss that is deductible and, at $50,000 or more, reportable.
• The asymmetry cuts against the taxpayer. A personal gain above $200 on a transaction is taxable, while a personal loss of any size is not deductible.

The dividing line between personal and investment holdings is a question of fact, and it is the single most important judgement in the preparation. A balance held in an interest-bearing sterling account as part of an investment portfolio is treated very differently from the proceeds of a house sale sitting in a current account awaiting the next purchase. The classification must be made consistently for gains and losses across years, and it should be documented at the time the return is prepared.

How is the $50,000 threshold measured?

The measurement rules catch out returns that net their currency results before testing them. Three points apply.

The loss is tested gross

The instructions state that a section 165 loss, for this purpose, does not take into account offsetting gains, other income or limitations. A taxpayer who realises an $80,000 exchange loss on one sterling loan and a $70,000 exchange gain on another in the same year has a net result of $10,000 but a reportable loss of $80,000.

The test is applied to the transaction

The regulation is framed by reference to a transaction resulting in a loss at or above the threshold in a single tax year. Whether a series of conversions, repayments or settlements forms one transaction or several is a question of fact. In our experience preparing these returns, a pattern of linked disposals from the same deposit or facility is usually analysed together, and where the position is uncertain a protective disclosure is the conservative course because there is no penalty for filing a Form 8886 that turns out not to have been required.

The full loss counts in the year it is sustained

The whole loss is counted in the year it is sustained, even if part of it cannot be used that year and is carried to another year as a net operating loss. Form 8886 is attached to the return for the year the threshold is first met and to any later return that reflects the loss.

A simple illustration shows how quickly the figure is reached. Suppose an American in London placed £1,000,000 on deposit as an investment when the rate was $1.35, giving a dollar basis of $1,350,000, and converted it to dollars when the rate was $1.28, receiving $1,280,000. The exchange loss is $70,000. It is ordinary, it is deductible because the deposit was held for investment, and it is reportable on Form 8886. A movement of seven cents on a seven-figure balance is enough.

Which currency losses are excluded from Form 8886 reporting?

Revenue Procedure 2013-11 lists categories of loss that are not taken into account in deciding whether a transaction is a loss transaction. The best known is the exception for a loss on the sale of an asset with a qualifying basis, broadly an asset bought for cash. It is the reason an ordinary loss on quoted shares, however large, does not normally require Form 8886.

That exception is of no help with currency. The revenue procedure expressly provides that the qualifying-basis exception does not apply where the loss is treated as ordinary under section 988, with a narrow carve-out for certain banks. An individual cannot rely on having paid cash for the sterling.

Other exclusions in the same revenue procedure can be relevant to individuals with currency positions:

• losses to which the mark-to-market rules of section 1256(a) apply, which can cover certain regulated futures and qualifying foreign currency contracts;
• losses arising from specified mark-to-market elections and treatments listed in the revenue procedure; and
• losses on properly identified hedging transactions within section 1221(b), which is a business hedging provision and seldom applies to a private individual.

Each exclusion has conditions, and none should be assumed without checking the instrument and any election actually made. The IRS summarises the regime on its page on the disclosure of loss reportable transactions.

Where does Form 8886 go?

There are two filing obligations, and missing the second is as common as missing the first.

1. Attach Form 8886 to the return. The form is attached to the income tax return for each tax year in which the taxpayer participated in the transaction, including any amended return that reflects the loss. If the loss is carried back, the form also goes with the carryback claim or amended return for the carryback year.
2. Send an exact copy to the Office of Tax Shelter Analysis. For the first year a transaction is disclosed, a copy identical to the one attached to the return must be sent to OTSA at the same time. The instructions give the address as Internal Revenue Service, OTSA Mail Stop 4915, 1973 Rulon White Blvd., Ogden, UT 84201, and also provide a fax route. Where the return is filed electronically, the OTSA copy must match the e-filed form exactly.

The form must be complete. It asks for the name and type of transaction, the tax year, the kind and amount of the tax benefit, the parties involved and a description of the facts and expected tax treatment. The instructions warn that entries such as a statement that information will be provided on request are treated as incomplete, and an incomplete form is treated as a failure to disclose. The current version and instructions are on the IRS page About Form 8886.

What is the penalty for a missed Form 8886?

Section 6707A imposes a separate penalty for failing to include reportable transaction information with a return. Its features differ from most penalties a private client will have encountered.

• Amount. The penalty is 75% of the decrease in tax shown on the return as a result of the transaction. For a reportable transaction that is not a listed transaction, the instructions give a minimum of $5,000 and a maximum of $10,000 for an individual. An individual's exposure for a currency loss transaction therefore sits in a narrow band for each failure.
• Per return. The penalty applies to each return on which the disclosure was required and omitted. An amended return that reflects the loss without the form is a further failure.
• No reasonable cause defence. Section 6707A contains no exception for reasonable cause or good faith. IRS examination guidance describes it as a strict liability penalty.
• Rescission. For transactions other than listed transactions, the IRS may rescind the penalty where doing so would promote compliance and effective tax administration. Treasury Regulation section 301.6707A-1 sets out the factors, and IRS guidance indicates that an inadvertent failure followed by a complete, if late, Form 8886 filed once the taxpayer became aware of the omission weighs in favour of rescission. A request has to be made within a short window after the penalty is notified, and a refusal cannot be challenged in court.

The penalty is assessed without the deficiency procedures that apply to income tax, so it does not carry the usual route to the Tax Court before payment.

Does a missing Form 8886 keep the tax year open?

This is widely misunderstood. Section 6501(c)(10) extends the period for assessment where a taxpayer fails to disclose a listed transaction, keeping the year open until one year after the information is eventually provided. A currency loss that is reportable only because it meets the loss threshold is not a listed transaction, and IRS guidance confirms that for other reportable transactions the limitation period generally follows that of the return itself.

That is not much comfort to a person with missed returns. Where no return has been filed for a year, the assessment period for that year has not started to run at all. And where a return was filed but omitted foreign information returns, a different provision, section 6501(c)(8), can hold the year open. In catch-up cases the open-year analysis is usually driven by those rules, not by Form 8886.

How is a missed Form 8886 handled on late or amended returns?

The right course depends on what has, and has not, already been filed.

The return for the year was never filed

The Form 8886 obligation arises when a return claiming the loss is filed. When the late return is prepared, the currency results are computed properly for the first time, each loss is classified as personal or deductible, and where a deductible section 988 loss meets the threshold a complete Form 8886 is attached, with the exact copy sent to OTSA for the first year disclosed. Later years that use any carried-forward part of the loss carry the form as well.

A return was filed that claimed the loss without the form

The failure has already occurred for that return. The corrective step is to file a complete Form 8886 as soon as the omission is identified, normally with an amended return, and to send the copy to OTSA. The late form does not remove the penalty automatically, but it is the foundation of any later rescission request, and the date the omission was discovered should be recorded.

A return was filed that ignored currency altogether

Many returns prepared without cross-border expertise simply treat sterling as if it were dollars. Correcting them means recomputing gains as well as losses. Because of the asymmetry described above, an amended return often brings in taxable exchange gains alongside any deductible loss, and the two cannot be netted for the purpose of the Form 8886 test.

How does Form 8886 fit inside a streamlined submission?

Americans abroad whose failures were non-wilful commonly use the Streamlined Foreign Offshore Procedures, which require the most recent three years of returns, six years of FBARs and a signed certification on Form 14653. Our IRS streamlined filing team treats Form 8886 as part of the return package for any of the three years in which a deductible section 988 loss meets the threshold.

Three points deserve attention.

• The streamlined returns must be complete returns. The procedure calls for returns together with all required information returns. A return that claims a reportable currency loss without Form 8886 is not complete.
• The OTSA copy is still required. The streamlined package is sent to the address given in the IRS streamlined procedures for taxpayers residing outside the United States. The separate copy for the Office of Tax Shelter Analysis is an additional obligation and is not satisfied by the streamlined mailing.
• The penalty relief is specific. The streamlined terms describe relief from failure-to-file and failure-to-pay penalties, accuracy-related penalties, information return penalties and FBAR penalties. The section 6707A penalty is not named separately in that list, so the prudent approach is to ensure every qualifying return in the submission carries a complete Form 8886 so that no failure arises in the first place.

A submission should also be internally consistent. If the certification narrative explains that the taxpayer did not understand that sterling movements had US tax consequences, the returns should then treat every currency item on the same footing, gains included.

What is the UK position on the same currency movement?

There is usually no UK position at all, and that is precisely the cross-border trap. For a UK resident, sterling is the home currency. Holding pounds, repaying a sterling loan or being repaid one produces no gain or loss for UK capital gains tax, because nothing has moved in sterling terms. The US exchange loss exists only because the US return is drawn up in dollars.

The picture is slightly different for dollar holdings, but the outcome is similar. Since 6 April 2012, gains and losses on withdrawals from a foreign currency bank account held by an individual have been outside UK capital gains tax, as HMRC explains in its Capital Gains Manual at CG78321. A US citizen in the UK who holds a dollar account therefore has no UK gain or loss on it either. HMRC notes that the change did not alter the treatment of other currency-related assets such as options and futures, which remain within the UK rules.

Item	US treatment (IRS)	UK treatment (HMRC)
Sterling deposit held as an investment	Exchange gain or loss under section 988, ordinary in character; loss deductible	No gain or loss; sterling is the home currency
Sterling current account for living costs	Personal transaction; gains over $200 per transaction taxable, losses not deductible	No gain or loss
Repayment of a sterling mortgage on a main home	Exchange gain taxable; exchange loss personal and not deductible	No gain or loss
Sterling loan made for investment or business reasons	Exchange gain or loss on principal under section 988	No currency gain or loss in sterling terms
US dollar bank account held by a UK resident	No exchange gain or loss; the dollar is the functional currency	Outside capital gains tax for individuals since 6 April 2012
Currency forward or option	Section 988 transaction unless a specific rule or election applies	Remains within UK tax rules for currency-related assets
Disclosure threshold	Form 8886 at $50,000 or more of section 988 loss in a tax year	No equivalent disclosure
Penalty for non-disclosure	Section 6707A; $5,000 to $10,000 per failure for an individual on a non-listed transaction	Not applicable

Two consequences follow. First, a UK accountant preparing the Self Assessment return has no reason to compute these figures, so nothing in the UK records will flag the issue. Second, there is no matching UK loss and no UK tax attaching to the same item, so the US result stands on its own. The US and UK returns need to be prepared with sight of each other, which is the approach our US-UK tax accountants take as standard.

What records are needed to prepare the disclosure?

Form 8886 cannot be completed from year-end balances alone. The preparation normally requires:

• complete statements for each sterling account, loan or instrument for the whole period, not only the years being filed, because basis depends on acquisition dates;
• the date and amount of each acquisition and disposal of sterling, with a consistently applied exchange rate source;
• loan agreements, drawdown and repayment schedules, and settlement confirmations for any forward or option;
• evidence of the purpose of each holding, which supports the classification as personal, investment or business;
• details of any elections made in relation to the instruments; and
• prior-year returns as filed, to identify how currency items were treated and whether any loss has been carried forward.

Individuals with larger balances also tend to have the related reporting obligations, including FBAR and Form 8938, and our FBAR penalty calculator gives an indication of the exposure where those are outstanding. Clients with more complex affairs are supported through our high net worth return preparation service.

Key points to take away

• An individual must file Form 8886 for a section 988 loss of $50,000 or more claimed in a single tax year, against a general loss threshold of $2 million.
• Sterling is a foreign currency for every US taxpayer, including one who lives permanently in the UK.
• Personal exchange losses are not deductible and so are not reportable; investment and business losses are both.
• The threshold is tested gross, without netting against currency gains.
• The cash-purchase exception in Revenue Procedure 2013-11 does not apply to ordinary losses under section 988.
• The form is attached to the return and, for the first year, copied to the Office of Tax Shelter Analysis.
• The section 6707A penalty has no reasonable cause defence, but rescission is available for non-listed transactions.
• The extended limitation period in section 6501(c)(10) applies to listed transactions, not to ordinary loss transactions.
• There is no corresponding UK gain, loss or disclosure.

Speak to us in confidence

If you have missed US tax returns, or have filed returns that claimed a large sterling loss without Form 8886, the position can be put right, and it is better addressed before the IRS raises it. Jungle Tax prepares the late, amended and streamlined returns, computes the currency results transaction by transaction, completes Form 8886 and the Office of Tax Shelter Analysis copy, and aligns the US filing with your UK Self Assessment. To arrange a confidential consultation, please contact our cross-border team.