For beginner forex traders, the goal is simply to make successful trades. In a market where profits – and losses – can be realized in the blink of an eye, many investors just want to "try their hand" before thinking long-term. While forex can be a confusing field to master, filing taxes in the U.S. for your profit/loss ratio can be reminiscent of the Wild West. Here is a breakdown of what you should know – even before your first trade.
See also: "Forex Walkthrough"
For Options and Futures Investors
Forex options and/or futures are grouped in what are known as IRC Section 1256 contracts. These IRS-sanctioned contracts mean traders get a lower 60/40 tax consideration. This means that 60% of gains or losses are counted as long-term capital gains/losses and the remaining 40% as short term.
The two main benefits of this tax treatment are:
When trading stocks held less than one year, investors are taxed at the same rate as their ordinary income. When trading futures or options, investors are taxed at a 23% rate (calculated as 60% long-term x 15% max rate + 40% short-term rate x max income tax rate).
For Over-the-Counter (OTC) Investors
Most spot traders are taxed according to IRC Section 988 contracts. These contracts are for foreign exchange transactions settled within two days, making them open to ordinary losses and gains as reported to the IRS. If you trade spot forex you will likely automatically be grouped in this category.
The main benefit of this tax treatment is loss protection. If you experience net losses through your year-end trading, being categorized as a "988 trader" serves as a large benefit. As in the 1,256 contract, you can count all of your losses as "ordinary losses" instead of just the first $3,000.
Which Contract to Choose
Now comes the tricky part: deciding how to file taxes for your situation. What makes foreign-exchange filing confusing is that while options/futures and OTC are grouped separately, you as the investor can pick either a 1256 or 988 contract. You have to decide before January 1 of the trading year.
IRC 988 contracts are simpler than IRC 1256 contracts in that the tax rate remains constant for both gains and losses – an ideal situation for losses. Notably, 1256 contracts, while more complex, offer more savings for a trader with net gains – 12% more. The most significant difference between the two is that of anticipated gains and losses.
At most accounting firms you will be subject to 988 contracts if you are a spot trader and 1256 contracts if you are a futures trader. The key factor is talking with your accountant before investing. Once you begin trading you cannot switch from 988 to 1256 or vice versa.
Most traders will anticipate net gains (why else trade?) so they will want to elect out of their 988 status and in to 1256 status. To opt out of a 988 status you need to make an internal note in your books as well as file with your accountant. This complication intensifies if you trade stocks as well as currencies. Equity transactions are taxed differently and you may not be able to elect 988 or 1256 contracts, depending on your status.
Keeping Track: Your Performance Record
Rather than rely on your brokerage statements, a more accurate and tax-friendly way of keeping track of profit/loss is through your performance record. This is an IRS-approved formula for record keeping:
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.
See also: "Top 4 Things Successful Forex Traders Do"
Things to Remember
When it comes to forex taxation there are a few things you will want to keep in mind, including:
- Deadlines for filing: In most cases, you are required to elect a type of tax situation by January 1. If you are a new trader, you can make this decision before your first trade – whether this is in January 1 or December 31. It is also worth noting that you can change your status mid-year, but only with IRS approval.
- Detailed record keeping: Keeping good records (and backups) can save you time when tax season approaches. This will give you more time to trade and less time to prepare taxes.
- Importance of paying: Some traders try to "beat the system" and earn a full or part-time income trading forex without paying taxes. Since over-the-counter trading is not registered with the Commodities Futures Trading Commission (CFTC) some traders think they can get away with it. Not only is this unethical, but the IRS will catch up eventually and tax avoidance fees will trump any taxes you owed.
The Bottom Line
Trading forex is all about capitalizing on opportunities and increasing profit margins, so a wise trader will do the same when it comes to taxes. Whether you are planning on making forex a career path or are interested in simply seeing how your strategy pans out, taking the time to file correctly can save you hundreds if not thousands in taxes, making it a transaction that's well worth the time.
See also: "Forex Trading Rules Tutorial"