TAXATION OF FOREX TRADING*
For U.S. federal tax purposes, net gain or loss from retail spot forex trading by U.S. residents can be treated in one of two ways: the same way that
net gain or loss from futures contracts on regulated commodities exchanges are treated under IRC Section 1256,
or as ordinary gain or loss under the special rules of IRC Section 988 (Treatment of Certain Foreign Currency Transactions).
Treating forex activity under Section 1256 is preferential when trading is profitable since it reduces overall tax on capital gains.
Even though most if not all of forex trading activity is short-term by nature and therefore, capital gains should be taxed at the short-term rate, by electing
to treat forex trading under Section 1256, the trader automatically receives the beneficial 60/40 tax treatment on these
capital gains: 60% is taxed at the lower long-term capital gains rate and 40% is taxed at the ordinary or short-term capital gains rate. This 60/40
tax treatment translates into a lower overall tax rate than had everything been taxed at the ordinary capital gains rate - a
significant tax advantage over, say, securities traders.
When forex trading activity results in a net loss, Section 988 is preferable because it eliminates capital-loss limitations, allowing full ordinary
loss treatment against any type of income. Losses under Section 1256, in contrast, can only be used to offset Section 1256 contract capital gains.
Section 1256 has a three-year carry-back feature but only against Section 1256 contract gains in those years.
OPTING OUT OF IRC 988
Retail forex trading activity by default falls under the provisions of IRC Section 988. However, the IRS gives the retail forex
trader the option of rejecting or opting out of Section 988 and electing that the gains be instead taxed under the
favorable 60/40 split of Section 1256. This is done by making an internal “capital gains election”. Even though the trader doesn't
have to file anything with the IRS to opt out, they are required to make this capital gains election "internally" before
starting to trade. In other words, the trader must keep a written record, signed and dated accordingly, about the fact that
they are opting out of Section 988. (See, for example, a sample resolution at right.)
Opting out of Section 988 may only be permitted for those gains or losses resulting from the trading of forex currency
pairs that have a futures contract counterpart on a regulated commodities exchange. This is the case for all of the major
currencies.
AN EVOLVING CLIMATE
Both IRC 1256 and IRC 988 tax codes deal with forex trading though neither presents a clear direction for the
retail forex trader. This coupled with the rapid growth in the retail forex market means that the taxation of
forex trading activity will likely come under greater regulatory scrutiny eventually leading to better clarification.
In the meantime, the U.S. retail forex trader should consult with a forex tax professional.
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Capital Gains Election
[TRADER NAME] hereby elects pursuant to Section 988(a)(1)(B) of the Internal Revenue Code of 1986, as amended,
to treat any foreign currency gain or loss attributable to a forward contract described in subsection 988(c)(1)(B)(iii) thereof, as capital
gain or loss, as the case may be, to the extent that such provision applies to contracts entered into by [TRADER NAME] on or after the date hereof.
This election will remain in force until affirmatively revoked by [TRADER NAME] and is hereby entered into the books and records of the
[TRADER NAME]'s foreign exchange trading activity.
________________________________
[TRADER NAME]
________________________________
DATE
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Taxation of Gain/Loss. Under Section 1256, the forex trader will report net capital gains on IRS Form 6781 (Gains and Losses from
Section 1256 Contracts and Straddles). In general, any net gain or loss is treated as: 40 percent short-term capital gain or loss and
60 percent long-term capital gain or loss. For example, if the maximum long-term capital gains tax rate is 15 percent and
the maximum short-term capital gains tax rate (i.e., ordinary income tax rate) is 35 percent, then the 60/40 blended tax rate is 23 percent.
Each forex position held open at year end is treated as if it were sold at fair
market value on the last business day of the tax year and the resulting gain or loss on each such open contract is also
treated as 60% long term and 40% short term, regardless of how long the position is held.
Note: The above is provided for informational purposes only. Please consult your tax professional.
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* This information is for educational purposes only and should not be construed as tax or investment advice of any kind.
Make sure that you consult with a tax professional about your forex taxes.