Foreign currencies are treated like any other capital asset, and the currency holder generally recognizes capital gain or loss (in dollar terms) when he converts the foreign currency to dollars. More importantly, if the foreign currency is used to buy something, the currency holder usually recognizes the unrealized gain or loss in the foreign currency at the time of purchase.
For example, let's say that an American traveler converts US$2 into 2 Canadian dollars. A week later, when that 2 Canadian dollars is worth US$3, he buys a Coke for 2 Canadian dollars. The American traveler has US$1 of taxable capital gain at the time of the Coke purchase, because he is treated as exchanging an asset purchased with US$2 for an asset worth US$3. In contrast, if the Canadian dollar had depreciated, the American would have a capital loss, but the loss would be a personal loss not deductible for tax purposes.
In order to simply matters a little bit, Internal Revenue Code section 988(e) provides an exception for personal transactions in foreign currencies after 1997.
The taxpayer does not have to recognize foreign currency gain if:
1. The gain is due to changes in exchange rates,
2. The transaction is a personal transaction (i.e., not a business or investment transaction, but transactions on a business trip are considered personal transactions), and
3. The gain is $200 or less.
The $200 limit is determined on a per transaction basis, not per year. There is little guidance on what constitutes a separate transaction for this purpose.
If the $200 limit is exceeded, then the entire gain (including the first $200 of gain) is subject to US tax. For example, if someone goes to Europe, converts $2,000 to 2,000 euros, spends half the euros, and converts the 1,000 euros left back to $1,300, that taxpayer might have to pay tax on the $300 of short-term capital gain in the transaction, though there would be zero tax if he converted only 600 euros to $780 at the same exchange rate.
Section 988 Treatment of certain foreign currency transactions.
(a) General rule.
Notwithstanding any other provision of this chapter—
(1) Treatment as ordinary income or loss. (A) In general. Except as otherwise provided in this section, any foreign currency gain or loss attributable to a section 988 transaction shall be computed separately and treated as ordinary income or loss (as the case may be).
(e) Application to individuals.
(1) In general. The preceding provisions of this section shall not apply to any section 988 transaction entered into by an individual which is a personal transaction.
(2) Exclusion for certain personal transactions. If— (A) nonfunctional currency is disposed of by an individual in any transaction, and (B) such transaction is a personal transaction, no gain shall be recognized for purposes of this subtitle by reason of changes in exchange rates after such currency was acquired by such individual and before such disposition. The preceding sentence shall not apply if the gain which would otherwise be recognized on the transaction exceeds $200.
(3) Personal transactions. For purposes of this subsection, the term “personal transaction” means any transaction entered into by an individual, except that such term shall not include any transaction to the extent that expenses properly allocable to such transaction meet the requirements of— (A) section 162 (other than traveling expenses described in subsection (a)(2) thereof), or (B) section 212 (other than that part of section 212 dealing with expenses incurred in connection with taxes).