How Forex Trades Are Taxed

Like any kind of trading or investment activity, the profits from foreign exchange (forex) trading are taxed as income. However, the tax treatment of gains on the forex market is different than other types of investments.

In a market where both profits and losses can be realized in a matter of seconds, forex traders may focus on making money in the short term without considering the longer-term ramifications. Before engaging in any trades, familiarize yourself with the tax implications of buying and selling forex so you can be prepared when tax time rolls around.

Taxes on Forex Trades

For tax purposes, forex options and futures contracts are considered IRC Section 1256 contracts. These are subject to a 60/40 tax consideration, which means the first 60% of gains or losses are counted as long-term capital gains or losses, while the remaining 40% are counted as short-term.

A 60/40 tax treatment is often favorable for individuals in higher 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. The maximum tax rate for ordinary income or short-term capital gains is 37%. The maximum long-term capital gains rate, however, is only 20%.

When trading futures or options, including forex, investors are effectively taxed at the maximum long-term capital gains rate on 60% of gains or losses and the maximum short-term capital gains rate on the other 40%.

Taxes for Over-the-Counter (OTC) Forex Traders

Most spot traders trading over-the-counter (OTC) are taxed according to IRC Section 988 contracts. These 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 1256 contract category, you can count all of your losses as "ordinary losses," not just the first $3,000.

Forex Spot Traders Have a Tax Choice

Now comes the tricky part: deciding how to file taxes for your situation. While options, 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.

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 and file the change with your accountant. Complications can intensify if you trade stocks and currencies because equity transactions are taxed differently, making it more difficult to select 988 or 1256 contracts.

Record Keeping for Forex Taxes

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 a popular formula used in forex record-keeping that follows four steps:

1. Subtract beginning assets from end assets (net).
2. Subtract cash deposits (to accounts) and add withdrawals (from accounts).
3. Subtract income from interest and add interest paid.
4. 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.

Tips for Managing Taxes as a Forex Trader

When it comes to forex taxation, there are a few habits you can adopt that will keep you in good standing with the IRS:

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

Details and accurate record-keeping will save you time when tax season approaches. You'll be able to spend more time trading and less time preparing 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. If you are audited, however, the tax avoidance fees and penalties will be greater than any taxes you might have initially owed.

The Bottom Line

In the United States, gains and losses from forex trading are taxed differently than other investment activities. Some forex trades are treated as 1256 contracts; traders using this designation treat the first 60% of gains or losses as long-term capital gains or losses, taxed at 20%. The remaining 40% of gains or losses are treated as short-term capital gains or losses, taxed at 37%. Spot forex traders can have their trades counted as 988 contracts, which are all taxed as ordinary income. This can be beneficial for traders who experience a net loss.

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.