Here is a case that illustrates what can go wrong with the IRS and foreign real estate.
Mr and Mrs Quijano bought a home in the UK for 297,000 pounds in 1986 and sold it in 1990 for 453,374 pounds.
Using the exchange rates at the time of purchase and sale, their basis for capital gain was 297,000 * 1.49 = $442,530 + $73,800 in improvements.
Their sale price was 453,374 * 1.82 = $825,140
They ended up with a capital gain of $308,811, which they paid taxes on.
At this point they decided to get clever and file an amended return claiming that their capital gain was only $199,491, by claiming that they had a Qualified Business Unit with the functional currency of British Pounds.
The tax court found that because they had not kept proper separate records in order to treat the mortgage and purchase as part of a trade or business and thus were not allowed to use British Pounds as the functional currency for the sale of the home.
The lesson is that if you want Qualified Business Unit treatment for the sale of your foreign home, you should talk to a US tax advisor before you buy it and make sure everything is set up correctly.
Also, get your story straight before you file your return. Filing an amended return with a dubious theory is just asking for trouble.
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