There are several ways for American retail traders to trade “currencies” and tax treatment varies.
1. U.S. regulated futures contracts
U.S. futures exchanges list the major currency pairs as regulated futures contracts (RFCs). Open a retail account with a CFTC-registered Futures Commission Merchant (FCM).
Currency RFCs automatically have Section 1256 tax treatment with lower 60/40 tax rates. Section 1256 requires mark-to-market (MTM) accounting, which means reporting realized and unrealized capital gains and losses. Because there is no way to generate a long-term capital gain with MTM, Congress agreed that 60% is a long-term capital gain, and 40% is a short-term capital gain, no matter of holding period. (See Section 1256 tax rates vs. ordinary rates below.)
2. Leveraged forex contracts off-exchange
Most American retail traders open accounts with a CFTC-registered Retail Foreign Exchange Dealer (RFED) or an FCM Forex Dealer Member. (See Learn Why The NFA Barred FXCM And What It Means For Forex Traders.)
By default, foreign currency transactions, including spot and forward forex contracts are Section 988 ordinary gain or loss tax treatment. A forex trader may elect capital gains treatment, which on short-term capital gains is the ordinary tax rate. If a forex trader doesn’t “take or make delivery” in cash, there is a case for using Section 1256(g) (foreign currency contracts) on “major” currencies. (See A Case For Retail Forex Traders Using Section 1256(g).)
3. Currency exchange-traded funds (ETFs)
Structured as Registered Investment Companies (RIC) listed on a securities exchanges, ETF RICs are securities with short-term vs. long-term capital gains and losses treatment, using the realization method. Short-term capital gains are subject to ordinary tax rates, and capital losses are subject to the $3,000 capital loss limitation against other income.
4. Nadex binary options and spreads based on forex
Nadex is a CFTC-registered derivative exchange offering binary options and spreads. Nadex bases one of its binary options products on price movements in forex. It’s not a forex contract. Nadex issues a Form 1099B for Section 1256 contracts, but I have doubts about their qualification for using Section 1256 tax treatment. Nadex binary options and spreads appear to be “swap contracts” with ordinary gain or loss tax treatment. (Read Tax Treatment For Nadex Binary Options.)
Section 1256 tax rates vs. ordinary rates
The difference in the 60/40 blended tax rate vs. short-term capital gains taxed at ordinary rates is significant throughout the graduated tax brackets. The 60/40 rates vs. ordinary rates are:
4% for the 10% bracket,
6% for the 15% bracket,
19% for the 25% bracket,
20% for the 28% bracket,
22% for the 33% bracket,
23% for the 35% bracket, and
28% for the top 39.6% bracket
No matter what tax bracket you are in, there are significant tax savings using Section 1256.
Additionally, there is a Section 1256 loss carryback election, which can be used to amend the prior three years tax returns, offsetting Section 1256 gains only. Section 1256 has summary tax reporting. It’s a breeze tax-wise.