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.
FX 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.
Forex/Currency Trader's Advantage: Section 1256
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?
Deciding whether to use or not use section 988 depends on the companies that profit from the fluctuation in foreign exchange rates as part of their normal course of business. 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. Therefore, 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.
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 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 reject Section 988? Even though you don't have to file anything with the IRS to reject, 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 rejecting Section 988.
Many FX 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.
When Tax Time comes, the forex traders don't receive 1099 forms from their broker at the end of the year like stock and futures traders do.
Nevertheless, they can pull up reports online from their accounts to do their own accounting or to seek the help of a tax professional. If you choose the do-it-yourself route, don't fall into the temptation of lumping your trades with your section 1256 activity. 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, forex traders continue to enjoy tax advantages by trading foreign currencies.
This information applies ONLY to United States' traders. Foreign investors that are not residents or citizens of the U.S.A. do not have to pay taxes on profits from foreign exchange.
This information is solely for the purpose of education and should not be taken as an investment or tax advice. Consult your tax advisor for foreign exchange tax advise.
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