UK mortgages and US taxes

My wife and I are moving to London in late January, and we recently visited London to search for a flat and make other preparations for the move.  We also visited a tax accountant in London who specializes in US/UK taxation.  We got a lot of great advice from him, but I'm still confused about one aspect of our conversation, on the subject of mortgages.

My wife and I are planning to buy a property a few months after we arrive, and we decided that an "offset mortgage" would be the best fit for our needs.  An offset mortgage combines your mortgage with checking, savings and credit card components (with the same interest rate applied to each component), so that any savings you build up can offset the current mortgage balance for purposes of computing the current monthly mortgage interest charge.  They come in two flavors, one where the different components reside in separate accounts, and one where everything is combined into a single pot of money (the latter more often being called a "current account mortgage").  The interest you save by offseting your mortgage balance in this way is not considered to be income and thus doesn't incur a tax liability in the UK (unless of course your savings exceed your mortgage balance).

I mentioned the idea of offset mortgages to the tax accountant, but he discouraged us from considering them for reasons I'm still trying to fully understand.  He seemed to think that, for purposes of US taxation, it would be very complicated trying to track each and every different kind of transaction going through the mortgage.  He also mentioned that the IRS will also want to tax any gain that might result from taking the mortgage out at one US/UK exchange rate and then paying it off at a different exchange rate, even though this would be a phantom gain if the mortgage payments were all made in UK sterling.

So I'm not sure I understand how one of these mortgages could complicate my US taxes, at least not the current account mortgage where everything is combined in a single pot of money with a single balance and single mortgage interest expense every month.  And the problem with the phantom gain arising from different exchange rates would seem to apply to all mortgages, not just offset mortgages.

What am I missing?  

Generally, if you buy a property in the UK and have a mortgage loan that is denominated in UK sterling (or any other currency thatn US $), whenever you pay off part or all of the principal of the loan, you need to calculate the currency gain or loss. This is a gain or loss that incur as a result of the fluctuation of US $ to UK£ from the time you took up the loan to the time that you pay it off.

Expample: You take up a mortgage loan in 2003 of £100,000 when the exchange rate US$ to UK £ is 1.6. in 2008 you sell the house and pay off the loan. The exchange rate in 2008 is 1.4. YOu currency gain or loss is calculated as follows:

loan taken £100,000 @ 1.6 = $160,000
Loan paid off £100,000 @ 1.4 = $140,000

In this case you have a currecy gain of $20,000 which although taxed as ordinary income, is foreign source income and therefore subject to foreign tax credit.  Therefore often all of this is obsorbed by excess foreign tax credit.

I hope this has answered your question. Let me know if you need me to elaborate..

Helen

Thank you Helen--this is very helpful.  From what you say, the foreign currency gain/loss applies to all non-$ mortgages we might take out in the UK, regardless of specific mortgage features.

So the other part of my question is whether there is something about the features of an offset or current account mortgage that might further complicate our US taxes or increase our US tax liability.

Please also note that although currency gain are reportable and taxable, currency losses are not deductible!!!!!!!!!

In answer to your question re offset or current account mortgage, I don't know enough about offset mortgage to make any comments. But what I will say is that the currency gain or loss is calculated during every year that you paid off any part of the principal of your mortgage. You don't calculate it only when you sell the property.