Tax levies on income from Forex trading differs from country to country, but with ‘Tax Day' a recent memory in the United States, it's important to address tax-related issues that may arise for Forex traders. Though this article attempts to address the multitude of issues that should be considered, I strongly advise anyone reading this article to consult with a tax advisor in order to ensure that their U.S. taxes are filed appropriately.
Section 1256
Currency traders involved in the Forex spot (cash) market with a U.S. brokerage firm, can choose to be taxed under the same tax rules as regular commodities or under the special rules of IRC Section 988 (Treatment of Certain Foreign Currency Transactions).
Under Section 1256, US-based individual Forex traders have a considerable advantage over stock traders. Forex traders are allowed to split their capital gains on Schedule D using a 60%/40% split when reporting on IRS Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles.) This means that 60% of the capital gains are taxed at the lower, long-term capital gains rate and the remaining 40% at the ordinary or short-term capital gains rate, which depends on the tax bracket the trader falls under which can be as high as 35%. This results in an average rate of 23%, which is 12% less than the regular (short-term) rate.
Section 988
U.S. companies, however, who trade with a U.S. Forex broker and profit from the fluctuation in foreign exchange rates as part of their normal course of business, fall under Section 988. This means their gains and losses from foreign exchange, such as buying and selling of foreign goods, are treated as interest income or expense and get taxed accordingly. Consequently, they do not receive the beneficial 60/40 split.
Currency traders are also exposed to daily exchange rate fluctuations so technically their trading activity should also fall under the provisions of Section 988. But because these daily fluctuations can be considered part of a trader's assets in the normal course of his business, the IRS gives the trader the option of rejecting or ‘opting out' of Section 988 and choosing to have the gains taxed under the favorable 60/40 split of Section 1256.
What does it mean to opt out? Basically, when you opt out you don't have to file anything with the IRS. However you are required to keep an internal record in your own books about the fact that you are opting out of Section 988.
Many currency traders in the United States wait until after the year is over before filing in order to see if there have been any gains from their trading activities. If there are, they claim that they elected out of IRC 988 to enjoy the beneficial Section 1256 treatment. If, on the other hand, the sum of the trades from cash Forex is negative, they remain with the traditional Section 988. Under the current tax law, it is very difficult to disprove whether the trader made the election at the beginning or at the end of the year and the IRS has not yet begun to fully monitor this activity.