Let me begin by saying I am in no way an accountant, or a lawyer, I have learned it’s best to do your own due diligence on these topics so I wrote this article and I hope it helps.
*This info is not to be construed in any way as advice, and is for forex educational purposes only. It may be best to consult with your tax accountant or attorney.
Forex Taxes Intro
When I switched to currency day trading, I was challenged by the lack of info on forex taxes. The web provided very little for spot Forex Day Traders looking to file their taxes. Filing day trading taxes can be a chore in itself, let alone not having the info available for due diligence. I was a bit perplexed by the lack of knowledge available even from many Forex brokers on this topic. Some brokers provide 1099’s, while others did not, I must admit it was a bit confusing. The fact is futures are easier to file for taxes, as they are specifically outlined by tax code. The challenge lies in spot Forex
Types of Currency Trading
There are two types of Currency day trading. Forex spot currency trading, and Futures currency day trading. Spot forex is day trading on the interbank market (no exchanges) and you must comply with a different set of rules. Currency trading in futures means you trade on a regulated commodities exchange and these futures are treated the same as other commodities and futures. While Futures currency trading uses the 1256 contract, the spot forex can use Section 988 or 1256.
Is Forex Taxed as Futures or Cash?
Currency traders who trade in spot Forex have the option to be taxed under the same tax rules as regular commodities (IRC (IRS Code) Section 1256 contracts) or under the special rules of IRC Section 988 (Treatment of Certain FX Currency Transactions). IRC 988 applies to cash Forex unless the trader elects to opt out.
To make it easy to understand currency traders are taxed similar to commodities traders, however, spot forex traders must “elect out” of section 988, if they want “60/40” capital gains rate treatment of section 1256.
Advantages of Filing 1256 for Currency Traders
Most currency traders elect to be treated like futures traders, in that their trading gains and losses are treated as section 1256 contracts.
Day Traders and long term investors report section 1256 contracts as capital gains and losses, this allows them to split the gains and losses 60/40 on Schedule D: 60 percent long-term, 40 percent short-term.
This 60/40 split gives traders an advantage over securities traders. 60% is taxed at the lower long term capital gains rates (up to 15%) and 40% is taxed at the higher short-term capital gains rates. I want to mention that it is important to note For 2013 the capital gains rate is 20% at it’s highest rate. (If you make 400,000 or more)!
The current maximum blended 60/40 rate is 23%, which is 12% less then the maximum rate of 35% on short term securities. I think 12% less in taxes is great! This makes day trading taxes easier and appealing for those who make nice profits in day trading.
Filing a 988 or 1256?
Filing the 988 provides that these fluctuations in exchange rate gains and losses and should be treated as ordinary income or loss and reported as interest income or interest expense. IRC 988 considers exchange rate risk in the normal course of business to be like interest. The important distinction is that 988 does not apply to currency futures.
Currency traders who trade currency futures (regulated futures contracts RFCs) are not affected by IRC 988, because they are not trading in actual currencies.
RFCs based on currencies are just like any other RFC on an organized exchange.
Additionally, since RFCs are marked-to-market at the close of each day (and year), in accordance with IRC section 1256, the economic and taxable gain or loss are the same. IRC 988 specifically mentions that RFCs and other mark-to-market instruments are exempt transactions.
The bottom line is that a currency trader may elect out of ordinary gain or loss treatment in IRC section 988, thereby falling back to the default section 1256 contract treatment; which is 60/40 capital gains and losses. Most currency traders will want to make this election for the tax-beneficial treatment of section 1256 (lower tax rates on gains).
Should I file 988?
If you have cash forex trading gains, you will prefer to elect out of IRC 988, to benefit from up to 12% lower tax rates on Section 1256 contracts.
Conversely, if you have cash forex trading losses, you may prefer ordinary loss treatment over Section 1256 capital loss treatment, so you may not want to elect out of IRC 988.
The rules require that you elect out of IRC 988 on a contemporaneous basis. This means that hindsight is not allowed and you must make your decision in advance of the trades; before you know if you will have gains or losses.
Forex Taxes and Filing
The election out of IRC 988 should be filed internally, which means you place it in your own books and records, as opposed to filing it with the IRS.
Some traders may bend the rules and after year-end if they have cash forex gains, however this is not recommended. In essence they claim they elected out of IRC 988, to use the beneficial IRC 1256 treatment.
Do I get a 1099?
Form 1099s report proceeds on securities transactions and some have supplemental information for total sales and purchases of securities options, mutual fund transactions and purchases of securities. Form 1099s do not report cash forex transactions or single stock futures. I want to make one distinction, if you trade with a Bank Citifx like me then you will get a 1099, otherwise you will not!
Hope this article helps, now back to trading!