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Below article on forex tax rules 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. Please, seek advice from a trader tax expert if you have any doubts on forex taxes.
Below article is written By Robert A. Green, CPA
Currency traders face complexities and nuances come tax time. Currency futures are treated like other types of futures; your accounting is a snap and you enjoy lower 60/40 blended tax rates. However, cash forex can be an accounting nightmare and you face higher ordinary tax rates, unless you “elect out” of IRC 988 for 60/40 treatment.
When it comes to forex trading, special tax rules apply. There are two distinct types of currency trading and each has profound differences in tax and accounting rules. First, you can trade in currency futures on regulated commodities exchanges and these futures are treated the same as other commodities and futures – as IRC section 1256 contracts. Or, you can trade “cash forex” in the interbank market (not on regulated futures exchanges) and you are subject to an entire set of special rules – as IRC section 988 contracts.
Before you file your tax return, or even better yet before you start trading, find out what you are trading – is it a Section 1256 contract or a Section 988 contract.
Many currency traders transact in both. Contracts on regulated commodities exchanges (“regulated futures contracts” (RFC) on currencies) and in the non-regulated "interbank" market (a collection of banks giving third party prices on foreign current contracts (FCC) and other forward contracts) – commonly known as “cash forex.”
Learn below how currency traders are taxed similar to commodities traders, except that interbank currency traders must "elect out" of IRC section 988 (the ordinary gain or loss rules for special currency transactions), if they want the tax-beneficial "60/40" capital gains rate treatment of IRC section 1256.
Currency trading is like commodity trading in general
Most currency traders seek to be treated like commodities and futures traders, in that their trading gains and losses are treated as section 1256 contracts. Both business traders and investors report section 1256 contracts as capital gains and losses on Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles). This allows them to split the gains and losses 60/40 on Schedule D: 60 percent long-term, 40 percent short-term. This 60/40 split gives commodities traders and investors an advantage over securities traders. 60% is taxed at the lower long term capital gains rates (up to 15%) and 40% is taxed at the higher short-term capital gains rates (or “ordinary rate” up to 35%).
The current maximum blended 60/40 rate is 23%, which is 12% less then the maximum rate of 35% on short term securities (or cash forex trading if you don’t elect out of IRC 988, see below). Certainly, a 12% tax rate reduction is worthwhile to pursue for all currency traders.
Cash forex is subject to IRC § 988 (treatment of certain foreign currency transactions)
The principal intention of IRC § 988 is taxation on foreign currency transactions in a taxpayer's normal course of transacting global business. For example, if a manufacturer purchases materials in a foreign country in a foreign currency, then the fluctuation in exchange rates gain or loss should be accounting for pursuant to IRC § 988. IRC § 988 provides that these fluctuations in exchange rate gains and losses should be treated as ordinary income or loss and reported as interest income or interest expense. IRC § 988 considers exchange rate risk in the normal course of business to be like interest.
IRC § 988 does not affect currency futures (RFCs)
Currency traders who trade currency futures (regulated futures contracts – RFCs) are not affected by IRC § 988, because they are not trading in actual currencies. RFCs based on currencies are just like any other RFC on an organized exchange. Additionally, since RFCs are marked-to-market at the close of each day (and year), in accordance with IRC section 1256, the economic and taxable gain or loss are the same. IRC 988 specifically mentions that RFCs and other mark-to-market instruments are exempt transactions.
IRC § 988 does affect Foreign Currency Contracts
When a currency trader uses the interbank market to transact in Foreign Currency Contracts and Other Forward Contracts, they are exposed to foreign exchange rate fluctuations, similar to a manufacturer stated above. However, the currency trader looks upon their currency positions as "capital assets" in the normal course of their trading activity (business or investment).
What this means is that a currency trader may elect out of ordinary gain or loss treatment in IRC section 988, thereby falling back to the default section 1256 contract treatment; which is 60/40 capital gains and losses. Most currency traders will want to make this election for the tax-beneficial treatment of section 1256 (lower tax rates on gains).
Foreign exchange traded currency futures
Many traders ask this question, ‘are currency futures trades done on foreign exchanges also taxed at 60/40 for U.S. citizens, or does 60/40 only apply to futures listed on US exchanges.’ There is a reasonable basis in fact and law to conclude that futures traded on certain foreign contract markets with either a CFTC Rule 30.10 exemption or No Action Letter are entitled to classification as Section 1256 contracts (e.g., commodities) with the result that “60/40” tax treatment is appropriate. For more details see http://www.greencompany.com/EducationCenter/GTTRecCommodities.shtml#foreignfutures.
To “elect out” of IRC 988 or not, that’s the question
If you have cash forex trading gains, you will prefer to elect out of IRC 988, to benefit from up to 12% lower tax rates on Section 1256 contracts. Conversely, if you have cash forex trading losses, you may prefer ordinary loss treatment over Section 1256 capital loss treatment, so you may not want to elect out of IRC 988.
Note that IRC 1256 losses may be carried back up to three tax years, but only against IRC 1256 gains in the prior three tax years. Ordinary losses may offset any type of income.
But, technically, it’s not a simple choice like this at the end of the year. The rules require that you elect out of IRC 988 on a “contemporaneous basis.” This means that hindsight is not allowed and you must make your decision in advance of the trades’; before you know if you will have gains or losses.
Can you bend the rules?
The election out of IRC 988 should be filed “internally”, which means you place it in your own books and records, as opposed to filing it with the IRS. Many traders do bend the rules and after year-end if they have cash forex gains, they claim they elected out of IRC 988, to use the beneficial IRC 1256 treatment. In fact, our firm has noticed hundreds of traders who don’t even know the rules and simply report their cash forex gains on Form 6781. Others report them on Form 1040 line 21 as ordinary income and just pay higher taxes, without knowing the difference.
We expect the IRS to catch up with all cash forex traders soon, after the explosion of cash forex in the online trading market. Don’t bend the rules and get into trouble, learn about the rules up front and follow them for success.
Currencies futures versus cash forex – what’s the accounting difference?
Currency futures traders have it easy, on two accounts. Not only do you get the lower-tax 60/40 treatment on trading gains, but you also have it much easier come tax time. Your brokerage firm sends you (and the IRS) a simple Form 1099 soon after year-end, reporting one number for your Section 1256 trading gain or loss for the tax year. Line 9 on that Form 1099 is “aggregate profit or loss.”
The “mark-to-market accounting” rules in Section 1256 make accounting a snap. Your brokerage firm simply adjusts your realized gains and losses with beginning and end of year unrealized gains and losses for a combined realized and unrealized gain or loss amount. On your tax return, report “aggregate profit or loss” on Form 6781 (the 60/40 form). Those 60/40 amounts are then transferred to Schedule D (capital gains and losses) – unless you carry back a Form 6781 loss to prior years.
Wow, if only all traders had it so easy on accounting!
Section 1256 futures traders don’t need any accounting solutions or programs; unless they want to check their brokerage firms, which may be a prudent idea. Securities and cash forex traders face accounting challenges come tax time. Form 1099s report proceeds on securities transactions and some have “supplemental information” for total sales and purchases of securities options, mutual fund transactions and purchases of securities. Form 1099s do not report cash forex transactions or single stock futures.
So these types of traders are on their own. Some brokerage firms offer online reporting, but many have unmatched trades and some say you can not rely on these reports for your tax returns. So if you trade in anything other then Section 1256 contracts, you will probably need your own accounting solutions or software programs.
Most good accounting programs are geared towards securities traders. For examples, this writer’s company offers GTT TradeLog, a leading program for active traders to download all transactions and calculate trading gains and losses, with wash sales or IRC 475 mark-to-market adjustments.
Here is a good accounting solution for cash forex
Money managers report cash forex trading gains and losses using a “Performance Record Approach.” These results are sufficient for tax authorities and reporting rates of return to investors. Use the same formula in a worksheet for your tax return. Here’s the formula to use on a worksheet template.
Ending net assets (at market value) less beginning net assets (at market value), less additions of cash, plus withdrawals of cash, equals net performance. Then subtract non-trading items like interest income, add interest expense and other expenses and you have net trading gains or losses on cash forex. If you don’t elect out of IRC 988, then you report your ordinary gain or loss from cash forex as “other income” on Form 1040 (line 21). If you elect out of IRC 988, add this amount to Form 6781 as “cash forex elected out of IRC 988.”
Your monthly statements may get you lost in the woods. If you try to figure out your cash forex gains and losses from your monthly brokerage statements you may get very confused and lost. We have clients that have different statements for each type of currency (e.g. US dollars, Japanese Yen, Swiss Francs, and Euros) and it can become a nightmare scenario to try and figure it all out. The performance record approach is a salvation and it’s accepted by the IRS.
My broker reported my cash forex along with my IRC 1256 contracts, is that ok?
A few brokers lump in cash forex in with IRC Section 1256 contracts on 1099 line 9 “aggregate profit or loss.” This is technically incorrect by law, but it may save you taxes and an accounting headache. Technically, cash forex are IRC 988 transactions and should be segregated from IRC 1256 contracts.
Perhaps, these brokers can argue that when you opened your cash forex account, you “contemporaneously” elected out of IRC 988 for IRC 1256 treatment, and that you qualify for such as a trader rather then a manufacturer type business. You should consult with a trader tax expert if this case applies to you. Also consider what happens if you have a large cash forex loss and you prefer ordinary loss treatment instead of Section 1256 treatment – so you don’t get stuck with the capital loss limitation of $3,000? You face difficulty in overriding a broker’s 1099 treatment for 1256 contracts. Consult with a trader tax expert who may be able to help.
Cash forex is the “wild west” of trading and IRS reporting
Cash forex is not regulated by the CFTC and it has been called the ‘wild west’ of trading. Cash forex is also the wild west when it comes to taxes and reporting trading gains and losses. There should be no 1099 reporting for cash forex, so you are your own sheriff when it comes to ‘rounding up’ the gain and loss numbers and paying your taxes (with the nuances of IRC 988).
A person visited our booth at the Online Trading Expo in NYC and ask if cash forex was taxable at all? She heard that many cash forex traders claimed they don’t pay any taxes on their gains. We told her the IRS sheriff will catch up with them soon and throw the book at them for tax avoidance.
Remember, Form 1099 rules are minimum reporting guidelines set forth by the IRS. New products are being created all the time and it takes years for the IRS to set the guidelines for how each product is reported on Form 1099s, if at all. Brokerage firms tussle with the IRS each year on what they must report; as it causes great stress and cost on their accounting systems. Many new and smaller cash forex brokerage firms have ramped up quickly to tap into the explosion of interest in cash forex – especially after the securities markets went into a bear spin a few years ago.
Many of these firms are not strong on reporting, systems or tax compliance, so you may be on your own when tax time comes. Before you open a cash forex account, ask your brokerage firm what kind of reporting and support they offer you.
Bottom line
Currency trading is a hot commodity in the market place, but not all currency contracts are taxed like commodities. Cash forex is subject to IRC section 988 rules and if you’re a trader, you can elect out of IRC 988, to be taxed like commodities – with beneficial 60/40 treatment. Before you start trading cash forex, find out if you brokerage firm will help you with trade accounting. If not, you may have a huge accounting headache on your hands come tax time. When it comes to currency trading, it’s wise to learn all the tax rules and consult with a trader tax expert.
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