How is forex trading taxed?

Discussion in 'Forex' started by GarySummers, Jul 3, 2010.

  1. Forex Taxes

    This applies to U.S. traders only. Foreign investors that are not residents or citizens of the United States of America do not have to pay any taxes on foreign exchange profits.

    This information is for educational purposes only and should not be construed as tax or investment advice of any kind. Make sure that you consult with a tax professional about your forex taxes.

    More and more investors from all over the world are accessing the largest financial markets online through their personal computers. As demand surges for foreign exchange trading, more and more U.S. Traders have to deal with taxation issues at the end of the year.
    Forex: Taxed as Futures or Cash?

    Currency traders involved in the forex spot (cash) market, can choose to be taxed under the same tax rules as regular commodities [IRC (Internal Revenue Code) Section 1256 contracts] or under the special rules of IRC Section 988 (Treatment of Certain Foreign Currency Transactions). IRC 988 applies to cash forex unless the trader elects to opt out.
    The Advantage of Section 1256 for Currency Traders

    Under Section 1256, forex traders can have a significant advantage over stock traders. By reporting capital gains on IRS Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles), forex traders are allowed to split their capital gains on Schedule D using a 60% / 40% split. This means that 60% of the capital gains are taxed at the lower, long-term capital gains rate (currently 15%) and the remaining 40% at the ordinary or short-term capital gains rate, which depends on the tax bracket the trader falls under (as high as 35%). This results in an average rate of 23%, which is 12% less than the regular (short-term) rate.

    If cash forex is subject to the Section 988 rules, how can a trader elect the more beneficial Section 1256 split? Please read on to find out more.
    To Opt Out or Not to Opt Out of Section 988

    Companies that profit from the fluctuation in foreign exchange rates as part of their normal course of business, fall under Section 988. This means their gains and losses from foreign exchange (such as buying and selling of foreign goods) are treated as interest income or expense and get taxed accordingly. Consequently, they do not receive the beneficial 60/40 split.

    Since forex traders are also exposed to daily exchange rate fluctuations, their trading activity falls under the provisions of Section 988 too - but don't worry. The IRS wants to be nice to you (so far). Because these daily fluctuations can be considered part of a currency trader's assets in the normal course of his business, the IRS gives the trader the option of rejecting (opting out) of Section 988 and electing that the gains be taxed under the favorable 60/40 split of Section 1256.

    What do you have to do to opt out of Section 988? Even though you don't have to file anything with the IRS to opt out, you are required to do so "internally" before starting to trade; i.e., you must keep records in your own books about the fact that you are opting out of Section 988.

    Many currency traders bend the rules by waiting after the year is over to see if they have any gains from their trading activities. If they do, they claim that they elected out of IRC 988 to enjoy the beneficial Section 1256 treatment. On the other hand, if the sum of the trades from cash forex is not positive, they stick with the traditional Section 988. Since (under the current tax law) it becomes very difficult to disprove whether the trader made the election at the beginning or at the end of the year, IRS has not yet begun to crack down on this activity.
    What does a Forex Trader do When Tax Time Comes?

    Forex traders should receive 1099 forms from their US-based broker at the end of the year like stock and futures traders do. No matter in what country your forex broker is based or what tax-related reports they provide, you could pull up reports online from your accounts and seek the help of a tax professional. No matter what you decide to do, don't fall into the temptation of lumping your trades with your section 1256 activity (if any). Forex transactions need to be separated into Section 988 reporting.

    Given the fact that the forex market is one of the fastest-growing financial markets around, it might eventually come under closer IRS regulation. In the meantime, traders continue to enjoy tax advantages by trading foreign currencies.

    Enjoy and happy trading!
  2. Thanks for the heads up, this is exactly what we need more of around here.

    There's no way I would risk doing this filing on my own. What kind of questions do I ask a potential tax accountant so I know that they know about all this stuff, and more?
  3. pismo10