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GreenTraderTax Blog
GreenTraderTax
August 16, 2012
Why do forex forward dealers issue 1099s, yet retail spot forex brokers do not?
By Robert A. Green, CPA and CEO of GreenTraderTax.com
Forbes blog version Keeping Straight With Forex Reporting Requirements
Did you receive a Form 1099 from your forex broker or bank this year? If you traded forex spot, you most likely did not. Conversely, if you traded forex forwards, you probably did receive a 1099, the kind used for Section 1256 contracts, like futures. But, how does this affect your tax filings?
1099 rules
The rules state that a 1099 should be issued for forex forwards, treating them like Section 1256(g) foreign currency contracts. Those same rules state 1099 should not be issued for forex spot trading. Some taxpayers mistakenly think if they don’t receive a 1099, they don’t have to report anything. That is very wrong — you need to report your trading gains and losses and other income, whether you receive a 1099 or not. That includes income from foreign brokers, too. If the 1099 is wrong, you must report the correct amount. It’s best to ask your broker or bank to correct the 1099 when you identify an error.
Spot vs. forwards
Most online forex traders have accounts with retail off-exchange forex brokers, most of whom only offer trading in the forex spot market. Spot settles in one to two days, whereas forwards settle in over two days. Brokers use the terminology T+1 for trade date plus one for a one-day settlement.
Retail forex brokers are not direct participants in the Interbank foreign exchange market. Rather, they are customers of Interbank forex dealers, and they make a derivative market for retail spot traders. Some of these retail forex brokers square their books on customer trades, and net the difference in the Interbank market, while others simply behave like a “house,” acting as market makers for their clients.
Professional and institutional forex traders like larger hedge funds have access to trading directly with forex dealers in the Interbank market. These forex dealers offer well-heeled clients access to forex forwards and options in addition to spot trading. Because forwards settle in over two days, they require more credit from traders, as they are high-leverage activities.
Rolling spot contracts
A leading forex dealer offers a “rolling spot” trading program. Instruments traded in this program are treated like forwards for purposes of 1099 issuance. CFTC Chairman Gary Gensler called these contracts futures-like. We understand that other forex dealers offer similar trading products, too.
These “rolling spot” forex contracts don’t have a fixed settlement date, as they are open ended contracts. While technically they could settle during a spot term of one to two days, they primarily settle during a forward term over two days. This dealer says these contracts act more like a forward contract than a spot contract, and therefore they issued a 1099 for forwards. That called for using a 1099 for Section 1256g (foreign currency contracts), which requires reporting of realized and unrealized gains and losses. This forex dealer marked open positions to market at year-end, too. But, forex by default has Section 988 ordinary gain or loss treatment.
1099s don’t dictate tax treatment
It’s very important to note that Form 1099s don’t dictate tax treatment. 1099 issuance rules call for 1099s based on a default standard — investor status.
One of our clients received a 1099 from this dealer showing a $100,000+ loss treated as Section 1256g. But this client never filed an opt-out election from Section 988 into Section 1256g. Does the issuance of this 1099 dictate the taxpayer’s tax treatment, or do his own facts, circumstances and elections dictate tax treatment? Good news, it’s the latter. See the example footnote below that we plan to include with this client’s 2011 income tax return. In this case, the client prefers Section 988 ordinary loss treatment, rather than Section 1256 capital loss treatment subject to the $3,000 loss limitation against ordinary income. Taxpayers don’t want broker-issued 1099s to force them into worse tax treatment.
Section 475 MTM business traders don’t let 1099s dictate their tax treatment, either
For over a decade our Section 475 MTM business securities traders report their trading gains and losses with ordinary gain or loss treatment on Form 4797, Part II. They mark open trading business positions to market at year-end and report them as well. This tax treatment departs significantly from 1099s issued for a default investor using the cash method of accounting. The IRS understands the difference.
Example tax return footnote for a forex client who received a Form 1099
Taxpayer received a Form 1099 treating his forex contracts like forwards (or forward-like). 1099 issuance rules state that a 1099 should be issued for forex forwards, treating them like Section 1256(g) foreign currency contracts. Those same rules say no 1099 should be issued for spot forex.
As agreed by the issuer of this 1099, Form 1099s do not dictate the taxpayer’s tax treatment, as the issuer is generally not aware of the taxpayer’s facts, circumstances and tax-treatment elections.
By default, forex spot and forward contracts have Section 988 ordinary gain or loss treatment. Traders holding these forex contracts as capital assets may file an internal contemporaneous “capital gains election” pursuant to IRC § 988(a)(1)(B) to opt out of section 988 and into capital gains and loss treatment. If such an election is made, then for forex forwards — and forward-like forex contracts, including spot forex in some cases — taxpayers may use Section 1256(g) (foreign currency contract) treatment, providing it’s in major currencies for which regulated futures contracts trade on U.S. futures exchanges, and the taxpayer does not take or make delivery of the underlying currency. See Treas. Reg. § 1.988-3(b).
Section 988 reports realized gains and losses only, whereas Section 1256(g) reports realized, plus mark-to-market unrealized gains and loss treatment at year-end, too. Section 988 is ordinary gain or loss treatment, whereas Section 1256(g) has lower 60/40 tax rates, with 60% a long-term capital gain, and 40% short-term capital gain treatment.
Taxpayer did not file an internal opt-out election from Section 988, and therefore he must report using the default Section 988 ordinary gain or loss treatment for realized gains or losses, only. If the taxpayer is an investor, he reports that ordinary gain or loss on line 21 of Form 1040 (Other Income or Loss). If the taxpayer qualifies for trader tax status (business treatment), he reports the Section 988 ordinary gain or loss on Form 4797, Part II ordinary gain or loss.
In order for the IRS to match the 1099 filed to taxpayer’s return, we report the Form 1099 (for 1256 contracts) on Form 6781 Part I, and next, we zero the same amount out off of Form 6781, so we can transfer the amount to the correct form and line of the tax return. Forex is reported in summary fashion, not line-by-line fashion as done for securities. The amount we transfer to the correct form and line is the realized gain or loss, only. Only Form 6781 includes year-end unrealized gains and losses too on a mark-to-market basis.
Bottom line
1099 issuance rules have always been confusing and misunderstood by taxpayers. When you receive a W-2, you simply report the tax information provided. It’s rare to find errors. Conversely, when you receive a Form 1099 from a broker or bank, you should not just report what’s displayed. You need to consider your own facts, circumstances and tax-treatment elections to report your correct taxable income, loss and expense. This year, securities traders face a barrage of problems with new IRS cost-basis reporting rules for 1099-B issuers. We are finding huge problems on these 1099s. (See our earlier blogs on this.) When it comes to taxes, take the control away from your broker and consult a trader tax expert when needed.
How To Pay Back MF Global Customers 100%
By Robert A. Green, CPA
Green's Forbes blog version. September 20, 2011
Iraqi Dinar Investing Does Not Trigger IRS Personal-Use Rules
By Robert A. Green, CPA
Green's Forbes blog.
My recent blog, “Is The Iraqi Dinar Worthless Paper Or Maker Of Millionaires?” generated a firestorm of comments and opposing views. Here are some additional tax answers to questions and comments made.
Various IRS publications discuss tax rules for physically-held currency held for personal-use, mentioning capital gains treatment on gains, and no tax-deductible loss (capital or otherwise) on personal-use losses. These are standard tax rules for personal-use property. Taxpayers may only deduct capital losses on investment (Section 212) or trade or business (section 162) property.
Taxpayers who purchase Iraqi dinars generally are buying dinars for investment purposes, not personal-use. An example of personal use would be buying euros to use while traveling in Europe for personal reasons.
When it comes to physically-held currency and forex transactions (spot and forward) held for investment or business use, Section 988 (foreign currency transaction) tax rules apply. Section 988 is ordinary gain or loss tax treatment. Good news, the capital loss limitation of $3,000 per year does not apply to Section 988 ordinary losses.
An investor holding forex as a capital asset may file a contemporaneous election to opt-out of Section 988 into capital gains and loss rules, otherwise known as the capital gains election. But if you invest in physically-held currency, Section 988 does not permit you to opt-out of Section 988.
In summary, if you heard from an accountant, the IRS or a friend that capital gains apply by default to physically-held currency, that answer is only correct for personal-use sales of physically-held currency. It’s incorrect for the sale of physically-held currency or forex held for investment or business purposes. And don’t forget, you can’t take a tax loss of any kind (capital or ordinary) on the sale of personal-use physically-held currency either. July 25, 2011
Iraqi dinar revaluation: Real consequences or just rumors?
By Robert A. Green, CPA
Green's Forbes blog version: Is The Iraqi Dinar Worthless Paper Or Maker Of Millionaires?
Postscript. After reading several good comments on my Forbes blog exposing the buy Iraqi Dinar get rich quick scheme as a scam, I want to make it very clear that I also believe it’s a scam. My intent for the original blog was to answer tax questions about holding physical currency as an investment, not to drill down into the Iraqi Dinar scheme. I may do just that in a follow-up post soon. -R.G.
Dozens of people have signed up for tax consultations with me over the years looking for a windfall profit on the U.S. government revaluation of the Iraqi dinars back into U.S. dollars. (In other words, people holding dinars could exchange them for dollars again.)
Most dinar investors are current and ex-military, warzone contractors and now speculators. A cottage industry of promoters has sprung up on the Internet promising dinar "get rich" schemes. Many have invested, say, $5,000 and they hope to make millions. I’ve always thought it was a scam, as it sounded too good to be true.
These people ask me about their potential large tax bills. Most hope for long-term capital gains tax rates, currently up to 15 percent. I have to give them the bad news — holding physical currency is considered ordinary gain or loss in Section 988 (foreign currency transactions). Unlike forex traders — who don’t hold physical currency and don’t take or make delivery — they can’t file a capital gains election to opt-out of Section 988 and into short- and long-term capital gains treatment. That means no lower 60/40 futures tax rate either (Section 1256). At least, it’s not considered a personal loss which otherwise can't be deducted, as is the case when a person returns from a vacation and exchanges his left over currency from that trip. Investors in dinars can deduct ordinary losses in Section 988, but few expect a loss.
Lords of Finance: The Bankers Who Broke the World by Liaquat Ahamed is about how the four leading central bankers (US, UK, France and Germany) navigated in and out of WWI and financed recoveries and German reparations. These central bankers went off and on the gold and new dollar standards by manipulating their exchange and interest rates and much more. This is how money and power (military and otherwise) go hand in hand. Our current situation begs the question: Did the Bush administration plan on — and is the Obama administration still considering — paying for part or all of the Iraq war by collecting taxes from the revaluation of the dinar?
If this scheme has any resemblance of reality, it could be an interesting revenue raiser for the government — and I know the government is hunting for revenue raisers and closing of tax loopholes.
Maybe the story here is just that it’s a scam. But, if rumors in the marketplace are true, and the dinar does revalue and allow conversion for most to pre-war levels, what are the ramifications for the government, Iraq, the military, investors and taxpayers? What’s holding up the revaluation? Can Iraq handle it? How much tax revenue does U.S., state and local governments stand to collect? How many ex and current military and contractors stand to become millionaires overnight? January 29, 2011
Spot forex update
By Robert Green CPA and Mark Feldman JD
It’s not clear if spot forex traders can elect out of Section 988 (ordinary gain or loss treatment) with a capital gains election into the lower 60/40 tax rates of Section 1256(g). Interbank (forex) forwards are allowed, but spot forex isn’t specifically mentioned and the IRS has been reluctant to expand the definition.
If you have significant trading gains on spot forex contracts, the Section 1256 tax rates (such as foreign currency forwards) — which are up to 12 percent lower than the ordinary tax rates currently — may be very material and desirable to you, your forex fund and/or managed account investors. Forex transactions are reported in summary form. It’s not clear in the tax code when you should use cash vs. MTM treatment. If using Section 1256(g), MTM treatment is required.
We will discuss these issues in our upcoming Forex Tax Webinar scheduled for March 1. A recording is available.
We will also discuss the fact that forex brokers generally don’t report rollovers as realized transactions. Most forex brokers treat rollover interest as part of forex trading gains and losses and we make a case for how brokers are correct in not treating it as interest income.
Another forex tax update
We last discussed forex tax treatment in our Forex Tax Update blog. Here’s an important update on further developments.
We’re having ongoing discussions about retail forex tax treatment, specifically spot forex, with IRS officials in charge of writing Section 1256 regulations (the lower 60/40 tax rates on futures). We’re also speaking with a wide spectrum of players in the industry to understand the various types of retail forex trading which exist. This process will culminate in a face-to-face meeting with the IRS officials. We hope to convince the IRS to provide formal written guidance stating that retail forex qualifies for Section 1256; failing that, we will seek informal guidance from the IRS. This process may take some time, but in the meantime, we will get a better sense of what the IRS is thinking, and this will help us advise our clients properly even before the IRS makes a decision.
We believe there is at least “substantial authority” for the view that retail forex qualifies for Section 1256(g) 60/40 treatment. However, you should realize that not all of what is commonly called “retail forex” or “spot forex” necessarily qualifies. For example, it’s necessary for the forex to be traded on the “interbank market,” and we need to determine that the particular forex platform that you use qualifies. It is therefore important that you speak with us so that we can determine whether your situation falls within 1256(g).
Is retail spot forex a true Interbank transaction?
Many retail forex brokers use a software trading platform like MetaTrader. In our phone discussions with IRS officials, we sensed friction in their view of retail trades executed on some retail software platforms, challenging if those trades are true transactions in the Interbank forex market.
One leading forex brokerage firm explained that they transact in large block trades for spot forex with a major bank in the Interbank market — we call that a wholesale trade — and the retail forex broker then breaks up those block trades into pieces, redistributing them to their retail customers. As we explained to the IRS, these are retail trades in the Interbank market that go through a wholesale/retail distribution model, just like in other industries.
We’ve heard that other forex brokers have less direct connection with the Interbank market and in a sense make their own market with retail customers, with the firm taking the other side of trades with their customers. Some of these brokers may net their book of long and shorts on given currencies and then cover their risk in the direct Interbank market. The IRS may seek to deny Section 1256(g) with these brokers claiming the trades don’t meet the requirement of being in the Interbank market. Remember, retail spot forex is “off-exchange.” We need more interaction with forex industry players to fine-tune our arguments here, so contact us to discuss it.
The NFA recently published enforcement actions and fines against retail forex brokers Gain Capital and IKON, citing among other issues “slippage” in prices from using their software platforms. Read those actions to learn more about how regulators view the retail forex marketplace using software trading platforms.
Section 1256(g) requirements are specific
Forex brokers are offering retail transactions based on wholesale transactions and price references in the Interbank market. The IRS may argue that if a retail broker makes a “house market” in offsetting trades with retail customers and doesn’t transact significantly in the Interbank market, their trades aren’t true Interbank trades.
In 1986, the IRS added Section 1256(g) foreign currency contracts to Section 1256 and specifically only included “forward contracts.” Electronic trading in spot forex wasn’t possible in 1986, it only became prevalent after 2000.
There are three IRS requirements for inclusion in Section 1256(g):
1. The forward forex contract is traded in the Interbank market
2. The forex contract can be marked.
3. The delivery is based on the value of the foreign currency.
This last point was the reason forex OTC options were bounced out of Section 1256(g) in Revenue Ruling 2007-71.
In a variety of financial instruments, plenty of financial institutions and players act as market makers, and transactions are routed in all sorts of different ways. In our view, it’s unfair for the IRS to assert that retail forex in any form is not a true Interbank transaction. It’s designed, packaged and sold that way and clients and regulators hold brokers accountable for pricing that matches prices in the Interbank market. If it walks and quacks like a duck, it’s a duck.
Will the IRS assert that spot forex is a physical currency?
Before spot forex can enter coveted Section 1256(g), it first must get a ticket out of Section 988, ordinary gain or loss rules. The IRS will only allow a foreign currency transaction to opt-out of Section 988 if it’s a forex contract for future delivery like forwards. Spot settles in 24 or 48 hours and clients trade it electronically, starting with a spot trade and either exiting or rolling over the position before it settles in 24 or 48 hours.
The IRS expressed some difficulty getting its hands around the idea that spot isn’t a physical currency; when Section 988 was drafted that’s what they had in mind. Spot forex was the bulwark of global corporations to exchange currency. Traders may opt out of Section 988 into capital gain or loss, but only on forex contracts for futures delivery. Does that include spot forex? Yes, it may, according to IRS guidance, if the trader doesn’t take delivery of the currency but exits the position before it settles in 24 or 48 hours.
Spot forex is like a short-term forward
We think the IRS will agree that spot forex is like a short-term forward contract for future delivery. An electronic trader doesn’t buy a currency to take delivery of it. In fact, they aren’t permitted (or qualified with credit) to take delivery. The industry practice is to force exits of those positions before settlement or the transactions are rolled over automatically by the broker, with the current price and margin adjustment necessary to stay in that position.
The CFTC commissioner argued to Congress that spot forex is futures-like — making a similar point about spot being a short-term forward.
One leading broker told us his clients didn’t even realize spot trades had to be exited in 48 hours — they figured all trades would be rolled over by the broker automatically, which is generally the case. Brokers don’t treat spot forex rollovers as realized (closed) transactions; they defer the gain or loss to the final sale of the contract, only making price and margin adjustments with each rollover.
Summary points
Here’s what we’re facing with our current IRS discussions on spot forex tax treatment: Spot forex is truly a short-term forward so traders may opt-out of Section 988 with the capital gains election. That part may not be a big deal to the IRS, since it may prefer that clients be subject to net capital-loss limitations ($3,000 for individuals) than remain in default Section 988 with unlimited ordinary-loss treatment.
It’s going to be difficult to get the IRS to formally agree on opening the coveted door to lower 60/40 tax rates in section 1256(g). Leaving Section 988 means spot isn’t a physical currency and it’s like a short-term forward forex contract. If we can show the retail trade is in the Interbank market, we should meet that first of three requirements for Section 1256(g). In our view, spot forex meets the second requirement that it can be marked, and third requirement that delivery is based on the value of the foreign currency.
Will a “substantial authority” opinion letter help?
Another point to consider is whether or not to get a “substantial authority” opinion letter, otherwise known as a tax opinion letter from a firm like our Green & Company CPAs, LLC.
If you take the position that retail forex qualifies for 1256(g), and the court rules against you, you would be subject to a 20 percent substantial understatement penalty (plus interest on that penalty calculated from the date the tax return was due, plus any extensions) unless you prove there was “substantial authority” for your position. This penalty would be based on the amount of your tax underpayment attributed to this posture taken on retail forex.
The substantial authority standard is less stringent than a “more likely than not” standard (a greater than 50 percent likelihood of being upheld in litigation). A taxpayer doesn’t have substantial authority for a position if it’s “fairly unlikely to prevail in court upon a complete review of the facts and authorities.” The regulations state the weight of authority supporting the treatment of an item must be substantial “in relation to the weight of authorities supporting contrary positions.”
Tax return disclosure
There’s an alternative to getting a substantial authority opinion. You could disclose on your income tax return that it’s based on your belief that retail forex qualifies for 1256(g), and the IRS isn’t allowed to assess the 20 percent substantial understatement penalty. Some taxpayers think tax return disclosure in this manner is undesirable because they may be flagging the item for the IRS, and it may increase the chances of an exam. Therefore, it is important for you to hire a firm like our own experienced in how and when to provide this disclosure.
Rollover trades and rollover interest
Each day or two the spot trade ends and traders must sell or rollover the trade; they can't take delivery of the currency itself. So long as the trader has not finally terminated his position in the currency, some forex platforms do not report a gain or loss on the exchange rate appreciation or depreciation.
There can be large movements in the exchange rate and a large unrealized gain or loss deferred through year-end. These forex platforms provide a year-end statement which doesn’t report the unrealized (in their view) exchange rate gain or loss; they only report the interest-rate spread changes daily — otherwise referred to as “rollover interest.”
When electing into 1256g, MTM is required and no deferral is allowed at year-end on open rollover positions, including both interest and currency appreciation /deprecation. Traders need to get this missing MTM information from their brokers to report the correct realized and unrealized gain/loss to the IRS at year-end.
Our tax preparers aren’t going to be happy with some of these situations, especially when a client stays in Section 988 and doesn’t use MTM reporting.
On one side of a rollover transaction, the rollover interest is being summarized by many forex brokers on their year-end reports — purportedly useable for tax reporting —and on the other side, the deferred rollover price appreciation or depreciation is not being reported on year-end reports. Depending on the type of carry trade” that a trader makes, this inconsistent tax reporting treatment may help or hurt them. We are working more on this area and expect an update on it from us soon.
Bottom line
Until the IRS publishes specific guidance on modern spot forex trading tax treatment, there are plenty of grounds for differing interpretations and tax return postures. We believe our arguments support “substantial authority” tax return positions and that tax return disclosure is probably a good idea if you do it in the right manner. Our CPAs and tax attorneys can help, so contact us soon.
Note about our tax opinion service
We offer our tax opinion service to new clients too. You don't have to be a current tax preparation client to use our service. New clients should start with a 30 or 60 minute consultation with our tax attorney Mark Feldman to discuss their situation and to see if a tax opinion on forex tax treatment is appropriate.