When it comes to taxes, forex traders can have the best of both worlds: ordinary loss treatment and lower 60/40 tax rates on gains.
“Forex” refers to the foreign exchange market where participants trade currencies, including spot, forwards or over-the-counter option contracts. In the forex industry and IRS content, it’s called the “Interbank” market.
Spot vs. forwards
Most online trading platforms and brokers only offer forex spot contracts. These contracts clear within two days, whereas forex forward contracts clear in over two days. If a trader wants to stay in a spot trade longer than two days, the broker offers a “rollover trade” which technically is a realized sale and purchase of a new position (but not all brokers treat it that way). Forex spot traders don’t take delivery of the foreign exchange. Investing in physical foreign currency is not forex.
Forex differs from trading currency RFCs (regulated futures contracts) on futures exchanges. Like other RFCs, currency RFCs are Section 1256 contracts reported on Form 6781 with lower 60/40 capital gains tax treatment.
Forex tax treatment
By default, forex transactions start off receiving ordinary gain or loss treatment, as dictated by Section 988 (foreign currency transactions). The good news is Section 988 ordinary losses offset ordinary income in full and are not subject to the dreaded $3,000 capital loss limitation — that’s a welcome relief for many new forex traders who have initial losses.
Forex tax elections
Section 988 allows investors and business traders — but not manufacturers — to internally file a contemporaneous “capital gains election” to opt-out of Section 988 into capital gain or loss treatment. One reason to do so is if you need capital gains to use up capital loss carryovers, which otherwise may go wasted for years.
Qualifying for Section 1256(g) lower 60/40 tax rates
The forex capital gains election on forex forwards allows the trader to use Section 1256(g) treatment with lower 60/40 capital gains rates on major currencies if the trader doesn’t take or make delivery of the underlying currency. “Major currencies” means currencies for which currency RFCs trade on futures exchanges.
The (g) section in 1256 was added in the mid-80s for “foreign currency contracts” but only forwards existed at that time. In Green’s Trader Tax Guide, we make a case for treating spot like forwards for this more favorable Section 1256(g) tax treatment. In a controversial revenue ruling, the IRS barred forex OTC options from it.
Forex accounting and tax reporting
Summary reporting is used for forex trades and most brokers offer good online tax reports. Spot forex brokers aren’t supposed to issue Form 1099-Bs at tax time. Section 988 is realized gain or loss, whereas with a capital gains election into Section 1256(g), mark-to-market (MTM) treatment should be used.
Section 988 transactions for investors are reported in summary form on line 21 of Form 1040 (“other income or loss”). Watch out for negative taxable income caused by forex losses without trader tax status; some of those losses may be wasted. (If you qualify for trader tax status, use Form 4797 Part II instead and the negative income will likely generate a NOL.) Section 1256(g) treatment uses Form 6781 just like other Section 1256 contracts.
There are several nuances and complexities in forex tax treatment, accounting and tax compliance that you should know about. For example, forex brokers handle rollover interest and trades differently. (We cover these issues and more in Green’s Trader Tax Guide.)
The CFTC and NFA regulate forex contracts, and brokers/platforms
RFCs have 30:1 nominal leverage, and the CFTC allows forex to have up to 50:1 leverage on major currencies and 20:1 on minor currencies. It’s a mistake to hunt for higher leverage offered at unregistered forex brokers and banks located in foreign countries, as that contravenes CFTC and NFA rules. Don’t bother setting up an offshore company as that doesn’t skirt these CFTC rules, and it makes a tax filing mess with no tax advantages. (Read our blogs on forex regulation.)
For more in-depth information on forex tax treatment and regulation, read Green’s Trader Tax Guide.Contact us for assistance