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Tax Treatment: Securities, Futures, Forex & More : Forex

FOREX
“Forex” is a trading-industry term which refers to trading spot, forwards or over-the-counter (OTC) option contracts on foreign exchange in the off-exchange “Interbank” market. Forex differs from trading currency regulated futures contracts (RFCs) on exchanges like the CME. Like other RFCs, currency RFCs are Section 1256 contracts reported on Form 6781 with lower 60/40 capital gains tax rate treatment.

Forex has unique tax treatment. By default, all off-exchange forex transactions start off receiving ordinary gain or loss treatment, as dictated by Section 988 (foreign currency transactions). The good news is that Section 988 forex ordinary losses offset ordinary income in full and ordinary losses are not subject to the dreaded $3,000 capital loss limitation against ordinary income. That’s a welcome relief for many new forex traders who have losses.

There’s further good news with flexible forex tax treatment elections. Section 988 allows investors and business traders to file a contemporaneous “capital gains election” to opt-out of Section 988 into capital gain or loss treatment reported on Schedule D. One reason to file this election is to generate capital gains in order to use up capital loss carryovers, which otherwise may go wasted for years.

With the capital gains election, it’s also possible to navigate your way into lower 60/40 tax rates of Section 1256(g) (labeled “foreign currency contracts”) on forex forwards. In 1986, Congress and the IRS modified Section 1256 by adding section (g) to accommodate “forex forwards,” provided the trader filed the Section 988 opt-out capital gains election on a contemporaneous basis. There are two further requirements for 1256(g): the forex forwards must be in major currencies for which currency RFCs also trade on exchanges, and the trader “does not take or make delivery of the underlying physical foreign currency.” (Note: A Section 988 opt-out capital gains election may never be filed on actual holding of physical foreign currency. Gains on personal currency holdings are capital and losses are non-deductible.)

The big tax question for most retail off-exchange forex traders is how to handle spot forex. Guidance from the IRS is uncertain on spot forex. We’ve done extensive work on forex taxation, and spot forex in particular. We believe that in many cases, spot forex can be treated like forex forwards, qualifying for lower 60/40 tax rates in Section 1256(g)..........................

This is an excerpt from chapter 3 of Green’s 2013 Trader Tax Guide • Copyright © 2013