For traders in foreign exchange, or forex, markets, the primary goal is simply to make successful trades and see the forex account grow. In a market where profits and losses can be realized in the blink of an eye, many just want to make money in the short-term without really thinking about the longer-term ramifications. Nevertheless, it usually makes some sense to consider the tax implications of buying and selling forex before making that first trade.
Forex Options and Futures Traders
For tax purposes, forex options and futures contracts are considered IRC Section 1256 contracts, which are subject to a 60/40 tax consideration. In other words, 60% of gains or losses are counted as long-term capital gains or losses, and the remaining 40% is counted as short term.
- Aspiring forex traders might want to consider tax implications before getting started.
- Forex futures and options are 1256 contracts and taxed using the 60/40 rule, with 60% of gains or losses treated as long-term capital gains and 40% as short-term.
- Spot forex traders are considered "988 traders" and can deduct all of their losses for the year.
- Currency traders in the spot forex market can choose to be taxed under the same tax rules as regular commodities 1256 contracts or under the special rules of IRC Section 988 for currencies.
60/40 tax treatment is often favorable for individuals in high income tax brackets. For example, the proceeds of stocks sold within one year of their purchase are considered short-term capital gains and are always taxed at the same rate as the investor's ordinary income, which can be as much as 37%. When trading futures or options, investors are effectively taxed at maximum long-term capital gains rate or 15% (on 60% of the gains or losses) and the maximum short-term capital gains rate of 35% (on the other 40%).
For Over-the-Counter (OTC) Investors
Most spot traders are taxed according to IRC Section 988 contracts, which are for foreign exchange transactions settled within two days, making them open to treatment as ordinary losses and gains. If you trade spot forex, you will likely be grouped in this category as a "988 trader." If you experience net losses through your year-end trading, being categorized as a "988 trader" is a substantial benefit. As in the 1,256 contract category, you can count all of your losses as "ordinary losses," not just the first $3,000.
Which Contract to Choose
Now comes the tricky part: Deciding how to file taxes for your situation. While options or futures and OTC are grouped separately, the investor can choose to trade as either 1256 or 988. Individuals must decide which to use by the first day of the calendar year.
IRC 988 contracts are simpler than IRC 1256 contracts. The tax rate remains constant for both gains and losses, which is better when the trader is reporting losses. Notably, 1256 contracts, while more complex, offer 12% more savings for a trader with net gains.
Most accounting firms use 988 contracts for spot traders and 1256 contracts for futures traders. That's why it's important to talk with your accountant before investing. Once you begin trading, you cannot switch from one to the other.
The rules outlined here apply to U.S. traders with accounts at U.S. brokerage firms.
Most traders naturally anticipate net gains, and often elect out of 988 status and into 1256 status. To opt out of a 988 status, you need to make an internal note in your books as well as file the change with your accountant. Complications can intensify if you trade stocks as well as currencies because equity transactions are taxed differently, making it more difficult to select 988 or 1256 contracts.
You can rely on your brokerage statements, but a more accurate and tax-friendly way of keeping track of profit and loss is through your performance record.
This is an IRS-approved formula for record-keeping:
- Subtract your beginning assets from your end assets (net)
- Subtract cash deposits (to your accounts) and add withdrawals (from your accounts)
- Subtract income from interest and add interest paid
- Add in other trading expenses
The performance record formula will give you a more accurate depiction of your profit/loss ratio and will make year-end filing easier for you and your accountant.
Things to Remember
When it comes to forex taxation, there are a few things to keep in mind:
- Mind the deadline: In most cases, you are required to select a type of tax situation by Jan. 1. If you are a new trader, you can make this decision any time before your first trade.
- Keep good records: It will save you time when tax season approaches. That will give you more time to trade and less time to prepare your taxes.
- Pay what you owe: Some traders try to beat the system and don't pay taxes on their forex trades. Since over-the-counter trading is not registered with the Commodities Futures Trading Commission (CFTC), some think they can get away with it. You should know that the IRS will catch up eventually, and the tax avoidance fees will be greater than any taxes you owed.
The Bottom Line
Whether you are planning on making forex a career path or are simply interested in dabbling in it, taking the time to file correctly can save you hundreds if not thousands in taxes. It's a part of the process that's well worth the time.