What Is Section 988 Gain or Loss on Foreign Currency?

A Section 988 gain or loss is the ordinary income or ordinary loss you recognize when the exchange rate moves between the time you book a foreign-currency transaction and the time you settle it. The rule comes from Section 988 of the Internal Revenue Code, and its defining feature is character: currency-driven gains and losses are taxed at your regular income tax rate, not the preferential long-term capital gains rate.¹ For most U.S. taxpayers, the U.S. dollar is the functional currency, so any transaction denominated in another currency can trigger this separate tax item on top of whatever gain or loss you have on the underlying deal.²

What Transactions Trigger It

The statute reaches four kinds of transactions denominated in a nonfunctional currency:¹

Debt instruments. Borrowing or lending in a foreign currency, including foreign-denominated bank loans and bonds where principal or interest is set in another currency.
Accrued payables and receivables. If your business invoices a customer in euros or owes a supplier in pounds, the exchange rate movement between the booking date and the payment date is a Section 988 item.
Forward contracts, futures, options, and similar derivatives tied to foreign currency values, unless the contract is already subject to the mark-to-market rules of Section 1256.
Dispositions of the currency itself. Holding euros in a bank account or as cash and later converting them back to dollars counts. The statute reaches physical currency, demand deposits, time deposits, and similar bank instruments.

The trigger is the use of a nonfunctional currency, not the nationality of the parties. Two U.S. companies transacting with each other in yen are still inside Section 988.

How the Gain or Loss Is Calculated

Section 988 isolates only the exchange rate movement. You compare the dollar value of the foreign-currency amount on the date the item was booked with the dollar value on the date it was settled. Any gain or loss on the underlying goods, services, or investment is a separate tax item, computed on its own.

A payable example. Your U.S. company buys equipment from a German supplier for €10,000 on January 1, when the rate is $1.10 per euro. You record an $11,000 payable. When you pay on March 1, the rate has moved to $1.05 per euro, so you only need $10,500 to buy the €10,000. The $500 difference is a Section 988 ordinary gain.¹

Flip it for a receivable. You invoice a U.K. customer for £5,000 when the rate is $1.30, booking a $6,500 receivable. By the time the customer pays, the pound has fallen to $1.20, and the £5,000 converts to $6,000. That is a $500 Section 988 ordinary loss.

Debt instruments run the same calculation on principal and on each interest payment separately, using the accrual-date rate compared with the payment-date rate. The gain or loss is recognized when a payment is actually made or received, not while the obligation sits on your books.

Which Exchange Rate to Use

The IRS does not publish an official rate. It will accept any posted rate as long as you use it consistently, and you must use the rate prevailing on the date you receive, pay, or accrue the item.³ Where more than one rate exists for the same currency on the same date, pick the one that most properly reflects your income.⁴ Practical sources include your bank, the Federal Reserve, published Treasury rates, and commercial providers like Oanda and XE. Switching sources to cherry-pick favorable numbers is the kind of thing that draws scrutiny.

Why Ordinary Treatment Matters

Ordinary treatment cuts both ways.

On the loss side, it is an advantage. A Section 988 loss is fully deductible against any kind of income, including wages, business profits, and investment income. Compare that to a capital loss, which can offset capital gains but only up to $3,000 of other income per year for individual taxpayers ($1,500 if married filing separately).⁵ A $50,000 Section 988 loss can wipe out $50,000 of ordinary income in the same year. A $50,000 capital loss with no gains to offset would take more than fifteen years to use up.

On the gain side, it hurts. Section 988 gains are taxed at your marginal rate, which can reach 37% for high earners, rather than the long-term capital gains rate of 0%, 15%, or 20%. The IRS views currency movement as part of the cost or benefit of doing business, not as an investment return.

The Capital Gain Election for Certain Contracts

There is one narrow escape from ordinary treatment, and it applies only to forward contracts, futures contracts, and options in foreign currency. Trade payables, trade receivables, debt instruments, and dispositions of the currency itself are locked into ordinary treatment.¹

To make the election, the contract has to be a capital asset in your hands and cannot be part of a straddle. You also have to identify the transaction on your books and records as one you are electing capital treatment for before the close of the day you enter into it. Miss that same-day window, and the contract stays on ordinary treatment permanently.

The election must be applied consistently. You cannot elect capital treatment on winning contracts while letting losing ones fall back to ordinary treatment for a full deduction. That is where most attempts to game the rules break down.

Personal Currency Conversions

Section 988 does not apply to personal transactions. A personal transaction is one where the expenses would not be deductible as business or investment expenses.¹ Buying euros for a vacation and converting the leftovers back at a better rate is outside the section.

For personal currency dispositions, there is a $200 de minimis rule. If your gain is $200 or less, you do not have to recognize it. If it exceeds $200, the entire gain is taxable, not just the amount above $200. Because it sits outside Section 988, that gain is capital rather than ordinary.

Losses on personal currency conversions are not deductible at all. General tax rules bar deductions for losses on personal-use property, and vacation money is personal-use property. Gains over $200 are taxable; losses give you nothing.

Cryptocurrency Is Not Covered

Section 988 does not reach digital assets. The IRS treats virtual currency as property, not as real currency, so gains and losses on Bitcoin and other cryptocurrencies are capital gains and losses under the general property rules, not Section 988 ordinary items.⁶ If you trade digital assets, this is not the framework that applies to you.

1
Office of the Law Revision Counsel. 26 USC 988 – Treatment of Certain Foreign Currency Transactions
2
Office of the Law Revision Counsel. 26 US Code 985 – Functional Currency
3
Internal Revenue Service. Yearly Average Currency Exchange Rates
4
Internal Revenue Service. Foreign Currency and Currency Exchange Rates
5
Office of the Law Revision Counsel. 26 US Code 1211 – Limitation on Capital Losses
6
Internal Revenue Service. Frequently Asked Questions on Virtual Currency Transactions