Forex Traders Tax

Tax Information for Forex Traders

I am by no means an authority on taxation of currency traders. The information I’m providing here is from my own research and should not be used in making your personal tax decisions.

If you trade forex, there are 2 scenarios where your taxes may differ.

1) Currency futures are regulated and therefore fall under the tax rules of IRC Section 1256 contracts.
2) Cash forex on the unregulated interbank market fall under special rules of IRC Section 988.

If you trade in currency futures, #1 would apply to you and you would receive a significant tax advantage. The advantage is that you are allowed under Section 1256 to split your capital gains, with 60% taxed at the lower long-term capital gains rate (currently 15%) and the other 40% at the ordinary or short-term capital gains rate of up to 35% which is based on your tax bracket. From everything I’ve read, tax season is a breeze for currency futures traders.

If you trade cash forex, like myself, you fall under IRC Section 988. You can opt out. From what I’ve read, opt out if you have a profitable year. Don’t opt out if you have losses for the year. The reason you can opt out is because the IRS enables you to if currency traders can consider currency rate fluctuations as part of their capital assets. Here is a quote from CPA Robert Green,

" When a currency trader uses the interbank market to transact in Foreign Currency Contracts and other Forward Contracts, they are exposed to foreign exchange rate fluctuations. However, currency traders look upon their currency positions as "capital assets" in the normal course of their trading activity (business or investment). What this means 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). "

So the bottom line is if you trade currency futures or cash forex, you can take advantage of Section 1256 to split your capital gains.