Tax Strategies for Forex Traders.
Forex: Know What You Trade to Avoid Tax Traps:
Forex, the foreign currency exchange market, can be a lucrative one indeed for traders skilled in its dynamics. This worldwide network of government central banks, commercial and investment banks, hedge funds, international corporations and brokerage firms enables traders to capitalize on the rise and fall of a currency dollar volume that exceeds $1.4 trillion every day, making it the largest and most liquid of the world markets.
But when income tax time rolls around, currency traders receive special treatment from the Internal Revenue Service, the subtleties of which can sometimes trip up the unsuspecting.
Here’s a look at the tax landscape for forex traders, and why it may be a good idea to have a Traders Accounting tax professional help guide you through the twists and turns.
Futures and Cash Forex.
Forex is traded in two ways: as currency futures on regulated commodities exchanges, which fall under the tax rules of IRC Section 1256 contracts, or as cash forex on the unregulated interbank market, which fall under the special rules of IRC Section 988. Many forex traders are active in both markets.
Because futures and cash forex are subject to different tax and accounting rules, it is important for forex traders to know which category each of their trades fall into so that each trade can be reported correctly to receive optimum tax advantage.
Section 1256: The Advantageous Split.
Forex traders receive a significant tax advantage over securities traders under Section 1256: reporting capital gains on IRS Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles) allows you to split your capital gains on Schedule D, with 60%
taxed at the lower long-term capital gains rate (currently 15%) and 40% at the ordinary or short-term capital gains rate of up to 35%. That combined rate of 23% amounts to a 12% advantage over the ordinary (or short-term) rate.
If you trade exclusively in forex futures, it’s smooth sailing come tax time; your trades fall under Section 1256 and automatically receive the 60/40 split.
But things get a little more complicated tax-wise if you dabble in cash forex, which is subject to Section 988 (Treatment of Certain Foreign Currency Transactions).
Section 988: To Opt Out or Not?
Section 988 was enacted as a way for the IRS to tax companies that earn income from fluctuations in foreign currency exchange rates as part of their normal course of business, such as buying foreign goods. Under this section, such gains or losses are reported and treated as interest income or expense for tax purposes, and do not receive the favorable 60/40 split.
Because forex futures do not trade in actual currencies, they do not fall under the special rules of Section 988. But as a currency trader, you are exposed daily to currency rate fluctuations, hence your trading activity would fall under the Section 988 provisions.
But because currency traders consider these fluctuations part of their capital assets in the normal course of business, the IRS enables you to opt out of Section 988, and thereby retain the favorable 60/40 split for these gains under Section 1256.
The IRS requires that you note “internally” your intention to opt out of Section 988 before making the trades; you are not required to notify the IRS. Obviously, some traders bend this rule based on their year-end outcome, and there seems little inclination on.
the part of the IRS to crack down, at least so far.
As a rule of thumb, if you have currency gains, you would benefit (reduce your tax on gains by 12 percent) by opting out of Section 988. If you have losses however, you may prefer to remain under Section 988’s ordinary loss treatment rather than the less favorable treatment under Section 1256.
Tax Time: Tougher for Currency Traders.
Forex futures traders tend to breeze through tax time; their brokerage firm sends them an IRS Form 1099, on which their aggregate profit or loss is listed on Line 9.
But since currency traders don’t receive 1099s, you are left to find your own accounting and software solutions. Don’t be tempted to simply lump your currency trades in with your Section 1256 activity, a common temptation; these trades need to be separated.
into Section 988 reporting, and in cases of loss, you could wind up paying more tax than necessary.
As a fast-growing market segment, forex trading is almost certain to come under greater IRS scrutiny in the future. An experienced Traders Accounting tax professional can help you file in full compliance with IRS rules and make the most of your tax advantages.
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Forex Taxation Basics.
For beginner forex traders, the goal is simply to make successful trades. In a market where profits - and losses - can be realized in the blink of an eye, many investors get involved to "try their hand" before thinking long term. However, whether you are planning on making forex a career path or are interested in seeing how your strategy pans out, there are tremendous tax benefits you should consider before your first trade.
While trading forex can be a confusing field to master, filing taxes in the U. S. for your profit/loss ratio can be reminiscent of the Wild West. Here is a break down of what you should know.
For Options and Futures Investors.
The two main benefits of this tax treatment are:
For Over-the-Counter (OTC) Investors.
The main benefit of this tax treatment is loss protection. If you experience net losses through your year-end trading, being categorized as a "988 trader" serves as a large benefit. As in the 1256 contract, you can count all of your losses as "ordinary losses" instead of just the first $3,000.
Comparing the Two.
The Solution: Choosing Your Category Carefully.
The two types of forex filings conflict but, at most accounting firms you will be subject to 988 contracts if you are a spot trader and 1256 contracts if you are a futures trader. The key factor is talking with your accountant before investing. Once you begin trading you cannot switch from 988 to 1256 or vice versa.
Most traders will anticipate net gains (why else trade?) so they will want to elect out of their 988 status and in to 1256 status. To opt out of a 988 status you need to make an internal note in your books as well as file with your accountant. This complication intensifies if you trade stocks as well as currencies. Equity transactions are taxed differently and you may not be able to elect 988 or 1256 contracts, depending on your status.
Keeping Track: Your Performance Record.
Rather than rely on your brokerage statements, a more accurate and tax-friendly way of keeping track of profit/loss is through your performance record. This is an IRS-approved formula for record keeping:
Subtract your beginning assets from your end assets (net) Subtract cash deposits (to your accounts) and add withdrawals (from your accounts) Subtract income from interest and add interest paid Add other trading expenses.
The performance record formula will give you a more accurate depiction of your profit/loss ratio and will make year-end filing easier for you and your accountant.
Things to Remember.
Deadlines for filing : In most cases, you are required to elect a type of tax situation by January 1. If you are a new trader, you can make this decision before your first trade - whether this is in January 1 or December 31. It is also worth noting that you can change your status mid-year, but only with IRS approval. Detailed record keeping : Keeping good records (and backups) can save you time when tax season approaches. This will give you more time to trade and less time to prepare taxes. Importance of paying : Some traders try to "beat the system" and earn a full or part-time income trading forex without paying taxes. Since over-the-counter trading is not registered with the Commodities Futures Trading Commission (CFTC) some traders think they can get away with it. Not only is this unethical, but the IRS will catch up eventually and tax avoidance fees will trump any taxes you owed.
Forex Trading and Taxes.
Seeing profits from forex trading is an exciting feeling both for you and your portfolio. But then, it hits you. What about taxes? The forex tax code can be confusing at first. This is because some forex transactions are categorized under Section 1256 contracts while others are treated under the Section 988 – the Treatment of Certain Currency Transactions.
Section 1256 provides a 60/40 tax treatment which is lower compared to its counterpart. By default, all forex contracts are subject to the ordinary gain or loss treatment. Traders need to “opt-out” of Section 988 and into capital gain or loss treatment, which is under Section 1256. There is no use in trying to wiggle out of your taxes. Every trader in the United States is required to pay for their forex capital grains.
More Information about Section 1256.
Section 1256 is defined by the IRS as any regulated futures contract, foreign currency contract or non-equity option, including debt options, commodity futures options and broad-based stock index options. This section allows you to report capital gains using Form 6781 from the IRS (Gains and Losses from Section 1256 Contracts and Straddles). Take note that you have to separate the capital gains on Schedule D in a 60/40 split. It is divided as such:
60% of the total capital gains are taxed at 15% which is the lower rate 40% of the total capital gains can be taxed to as high as 35%. This is the ordinary capital gains tax.
More Information about Section 988.
In this Section 988, the gains and losses from forex are considered as interest revenue or expense. Because of this, capital gains are also taxed as such. The 60/40 split is not used and traders can expect to pay more if they fall under this section. The Section 988 is also complicated because forex traders have to deal with currency value changes on an everyday basis.
However, the IRS also made some provisions that will allow daily rate changes to be considered part of the trader’s assets or a part of the business. As a result, you can opt-out of Section 988 and then tax your capital gains using Section 1256.
How to Opt Out of Section 988.
The IRS does not really require a trader to file anything in order to opt out. But it is important to keep an “internal” record that shows that you have decided to opt out of Section 988. Many forex traders wait for about a year before opting out of this section. Why? They are just observing how much profit they can make from forex trading.
Form 8886 and Trading Losses.
If you suffered large losses you may be able file Form 8886 (see below for form). If your transactions resulted in losses of at least $2 million in any single tax year ($50,000 if from certain foreign currency transactions) or $4 million in any combination of tax years you may be able file form 8886.
Paying for the Forex Taxes.
Filing the tax itself isn’t hard. A US-based forex trader just needs to get a 1099 form from his broker at the end of each year. If the broker is located in another country, the forex trader should acquire the forms and any related documentations from his accounts. Getting professional tax advice is recommended as well.
As you can see, there is nothing difficult about paying for forex profits at this point. However, as this trading becomes more popular, the IRS is bound to come up with more measures that will regulate the trade. But if there’s one piece of advice you should take from this, it’s to always pay your taxes.
Trader Tax Forums, and Websites*
Green Company: Details on currency trading taxes.
Traders Accounting: They have written a lot of educational resources about trading and taxes.
Google Answers: Question is a few years old, can still has a lot of information.
Intuit Community Forum: Post questions and get answers from the people of Intuit.
*Online Forex Trading does not promote any of these forums or websites. They are shown purely for educational purposes In other words, please research these sites and use common sense if they ask you for money.
**Disclaimer - The information provided is for educational purposes. We are not tax professionals and we suggest you contact one.
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How Currency Traders Can Reduce Their Taxes.
The foreign exchange market, or forex, as it is more commonly called, is the biggest market in the world with over $4 trillion changing hands every single day. To put that into perspective, it is 12 times greater than the average daily turnover on the global equity markets and more than 50 times greater than the average daily turnover on the NYSE.
Trading in foreign currencies has been around for thousands of years. In fact, some of the first known currency traders were the Middle Eastern moneychangers who exchanged coins to facilitate trade. Given a market this size, it is no surprise that the taxation of forex remains a complexity to most traders and tax professionals.
A LITTLE BACKGROUND.
The Tax Reform Act of 1986 instituted the provisions covering Section 988 transactions.
Section 988 transactions, the default method of taxation for currency traders, treats the gains or losses from forex transactions as ordinary gains or ordinary losses. If you have forex gains, they are taxed as ordinary income, subject to which ever tax bracket you fall under. Let's look at an example:
Joe Trader is married and makes $100,000 salary a year. He has a good year trading FOREX, making $50,000 for the year. Joe falls in the 25% tax bracket, making his tax due on his FOREX gain $12,500 ($50,000 X 25%).
BUT WHAT ABOUT FOREX LOSSES?
If you lose money trading FOREX, your losses are treated as ordinary losses, and can be used to offset any other income on your tax return. Let's use Joe as an example again:
Instead of making $50,000, Joe loses $50,000 trading forex. The $50,000 loss can be taken against his W-2 income, making his taxable income $50,000 ($100,000 - $50,000). If his forex loss were a capital loss instead of an ordinary loss, Joe would only be able to take $3,000 off of his taxes, making his taxable income $97,000. The remaining $47,000 loss would have to be carried forward and used up in future years.
So what type of FOREX trader benefits from Section 988 tax treatment? In my opinion, if a trader is not consistently profitable and has other earned income on their tax return, they should stay under the Section 988 taxation to be able to fully utilize any losses that come from FOREX trading. If you are not consistently profitable in your FOREX trading AND you have no other earned income, you should consider doing what profitable FOREX traders should do: opt out of Section 988 tax treatment. I'll explain why at the end of the article.
IRC section 988(a) (1) (B) provides FOREX traders with a way to opt out of the ordinary gain/loss tax treatment:
"Except as provided in regulations, a taxpayer may elect to treat any foreign currency gain or loss. as a capital gain or loss (as the case may be) if the taxpayer makes such election and identifies such transaction before the close of the day on which such transaction is entered into".
This exception gives forex traders the option to opt out of ordinary gain/loss treatment; making your forex trades taxed the same as section 1256 contracts. Section 1256 contracts are taxed at a more beneficial rate of 60/40, 60% taxed at long term capital gains rates and 40% taxed at short term capital gains rates. The maximum tax rate on ordinary income currently is 39.6%. The maximum tax rate on Section 1256 contracts by comparison is 28%, almost a 30% reduction in taxation on the gains!
Using our example above, if Joe had opted out of the Section 988 tax treatment, his tax rate on his $50,000 FOREX gain at a 60/40 rate would drop 24% (19% vs. 25%), saving him $3,000 in taxes that year!
Here is a comparison of ordinary tax rates vs. the 60/40 tax rate using 2013 tax brackets:
The IRS requires a trader to make the election to opt out of Section 988 tax treatment internally, meaning you make the opt out election in your own corporate books or records. You do not have to notify the IRS in advance, as you do if you were making the mark to market election. I'd personally suggest having your opt out election notarized, which would help solidify your claim of a timely election if you got audited.
THE BOTTOM LINE.
Opting out of Section 988 tax treatment for forex traders is a no-brainer decision for profitable traders due to the tax savings. However, it also makes sense for traders who are not consistently profitable yet but also don't have any earned income on their tax returns. If a trader has an ordinary loss and no earned income to offset it against, the ordinary loss ends up being wasted as it cannot be carried forward to future tax years. If you opt out and elect Section 1256 tax treatment, the loss can be carried forward and used against future capital gains.
If you are still uncertain as to whether to opt out or not, please seek out the advice of a knowledgeable trader tax specialists to assist you with this decision.
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