Many preparers mess up forex tax treatment, and IRS and state agents are confused over the reporting, too.

“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. 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.

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 TTS; some of those losses may be wasted. (If you qualify for TTS, 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.

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.

The big tax question for most retail off-exchange forex traders is how to handle spot forex. (Get Green’s 2017 Trader Tax Guide for the entire content on this issue.)

The Section 988 opt-out election

The election to opt out of Section 988 must be filed internally (meaning you don’t have to file an election statement with the IRS) on a contemporaneous basis (meaning the IRS does not allow hindsight). Section 988 talks about the election on every trade, but you can also make a “good to cancel” election which is more practical. The election can be made and withdrawn throughout the year.

Forex OTC options

Few retail traders have access to trade forex OTC options. Per TaxNotes, “Representing a turnaround from what was understood to be prior law, the Sixth Circuit Court of Appeals held Jan. 7, 2016, that over-the-counter (OTC) foreign currency options are subject to mark-to-market accounting under section 1256.” In 2007, the IRS had barred forex OTC options from Section 1256.

A word of caution

If you don’t have TTS and you don’t elect out of Section 988, your forex trading losses can become wasted in the event you have negative taxable income. If you do qualify for TTS, those forex losses become a part of your NOL; but again, investors don’t have NOL treatment. Investors with no other source of income may be better off electing out of Section 988 so their forex losses can be classified as capital-loss carryovers and not wasted forever.

Physically held currency

Tax treatment varies when holding physical foreign currency. For investors and business traders, Section 988 rules apply, and you can’t file a capital gains opt-out election, as the IRS permits the capital gains election for spot and forward contracts only. That means investing in physical currency is ordinary gain or loss treatment in Section 988.

For personal use of currency such as on a vacation, losses are not deductible, while gains are considered capital gains. Section 988 and the capital gains election don’t apply on personal use of currency. Some traders look for answers on currency taxation in IRS publications and they find this answer about personal use currency, but it only applies to currency held for personal use — not investing and trading forex. Traders and investors use Section 988 by default.

For extensive content on forex tax treatment, accounting and reporting, read Green’s 2017 Trader Tax Guide.