Many taxpayers, preparers and IRS agents mishandle forex tax treatment.
“Forex” refers to the foreign exchange market where participants trade currencies, including spot, forwards or over-the-counter option contracts. 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.
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.
The 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 U.S. futures exchanges. There are lists of currency contracts including pairs that trade on U.S. futures exchanges available on the Internet. In our tax guide, we make a case for treating spot like forwards for purposes of using Section 1256(g) treatment.
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.