The fundamental aim for traders in foreign currency, or forex, markets is simply to make profitable deals and watch their forex account increase. In a market where gains and losses may be achieved in the blink of an eye, many people seek to earn money in the short term without considering the long-term consequences. Nonetheless, before making that first deal, it is always a good idea to think about the tax consequences of buying and selling forex.
Forex Options and Futures Traders
For tax reasons, FX options and futures contracts are classified as IRC Section 1256 transactions, which are taxed at a 60/40 split. In other words, 60% of profits or losses are considered long-term capital gains or losses, while the remaining 40% are considered short-term capital gains or losses.
- Before starting started, aspiring forex traders should think about the tax consequences.
- Forex futures and options are 1256 contracts that are taxed under the 60/40 rule, which treats 60% of profits or losses as long-term capital gains and 40% as short-term capital gains.
- Spot FX traders are classified as “988 traders” and may deduct their whole year’s losses.
- Currency traders in the spot forex market have the option of being taxed under the same rules that apply to conventional commodities 1256 contracts or under the unique regulations of IRC Section 988 for currencies.
Individuals in high income tax levels sometimes benefit from a 60/40 tax arrangement. The earnings of stocks sold within one year of acquisition, for example, are considered short-term capital gains and are always taxed at the same rate as the investor’s regular income, which may be as high as 37%. Investors who trade futures or options are effectively taxed at the maximum long-term capital gains rate of 20% (on 60% of the profits or losses) and the maximum short-term capital gains rate of 37% (on the remaining 40%).
For Over-the-Counter (OTC) Investors
Most spot traders are taxed under IRC Section 988 contracts, which are for two-day foreign currency transactions that may be treated as ordinary losses and profits. If you trade spot FX, you will most likely be classified as a “988 trader.” If you have net losses from your year-end trading, being classified as a “988 trader” is a significant gain. You may include all of your losses as “ordinary losses,” not just the first $3,000.
Which Contract to Choose
Now comes the difficult part: determining how to file taxes for your specific scenario. While options, futures, and OTC are separated, the investor may trade as either 1256 or 988. Individuals must choose which to use by the start of the year.
IRC 988 contracts are easier to understand than IRC 1256 contracts. When the trader reports losses, the tax rate stays identical for both profits and losses. Notably, although 1256 contracts are more difficult, they provide 12% greater savings for a trader with net profits.
For spot trading, most accounting companies utilize 988 contracts, whereas futures traders use 1256 contracts. That is why, before investing, you should consult with your accountant. You cannot swap from one to the other once you begin trading.
The following regulations apply to US traders having accounts at US brokerage companies.
Most traders expect net profits and often opt out of 988 status and into 1256 status. To opt out of a 988 status, make an internal notation in your records and notify your accountant of the change. If you trade stocks in addition to currencies, complications might arise since equities transactions are taxed differently, making it more difficult to choose 988 or 1256 contracts.
You may depend on your brokerage statements, but your performance record is a more accurate and tax-friendly manner of tracking profit and loss.
This is an IRS-approved formula for record-keeping:
- Subtraction of initial assets from ending assets (net)
- Subtract cash deposits from withdrawals (from your accounts) (from your accounts)
- Subtraction of revenue from interest and addition of interest paid
- Add in other trading expenses
The performance record formula will provide you with a more accurate representation of your profit/loss ratio, making year-end filing simpler for you and your accountant.
Things to Remember
There are a few factors to bear in mind when it comes to currency taxation:
- Remember the deadline: In most circumstances, you must choose a kind of tax situation before January 1. If you are a rookie trader, you may make this selection whenever you want prior to your first deal.
- Maintain accurate records: It will save you time when tax season comes around. This means you’ll have more time to trade and less time to prepare your taxes.
- Pay your taxes: Some traders attempt to game the system by not paying taxes on their forex trading. Some believe they may get away with it since over-the-counter trading is not regulated with the Commodity Futures Trading Commission (CFTC). You should be aware that the IRS will ultimately catch up with you, and the tax evasion fines will be more than the taxes you owing.
The Bottom Line
Whether you want to make forex a profession or merely dabble in it, taking the effort to file properly may save you hundreds, if not thousands, of dollars in taxes. It’s an important element of the process that’s well worth your time.
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