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. Forex differs from trading currency futures on futures exchanges. Like other futures, currency futures are Section 1256 contracts reported on Form 6781 with lower 60/40 capital gains tax treatment.
Many traders, preparers, and IRS agents misunderstand forex tax treatment, and we often see errors. The first problem is there is no 1099-B for spot forex and most trade spot forex, not forex forwards, or forex OTC options.
Most preparers err in thinking it’s a capital asset for traders so capital gains and loss treatment should apply. That’s incorrect: The default treatment in Section 988 forex rules is ordinary gains and losses, not capital gains and losses. That’s a welcome relief for many new forex traders who have initial losses, who are grateful not to have a $3,000 capital loss limitation against other income.
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 the 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. A trader may make or retract this election on a “good to cancel basis” during the year.
The capital gains election on forex forwards allows the use of Section 1256(g) treatment with lower 60/40 capital gains rates on the main currencies if the trader doesn’t take or make delivery of the underlying currency. “Main currencies” means currencies for which currency futures trade on U.S. futures exchanges. Go to U.S. futures exchanges to find a listing of their currency pairs.
Using Section 1256(g) requires the forex broker to have direct access to the Forex Interbank market. A forex broker that takes the opposing trade with clients and only enters the Interbank market to make a few offsetting trades does not qualify for lower Section 1256(g) 60/40 tax rates.
In our tax guide, we make a case for treating spot like forwards for purposes of using Section 1256(g) treatment. Spot forex tax treatment is uncertain, so it’s wise to consult with us about it.
Use summary reporting for forex trading, and most brokers offer good online tax reports. Section 988 is realized gain or loss, whereas with a capital gains election into Section 1256(g), use mark-to-market (MTM) treatment.
There are many nuances, myths and widespread errors with forex tax treatment, and GreenTraderTax is considered the leader in forex tax treatment. Forex tax is one case where we highly recommend our trader tax guide and the above recording for sale. Consider a consultation with us and our tax compliance service.