Forex Tax Treatment
Get the best of both worlds with forex taxes: Ordinary losses in Section 988 or elect capital gains for a chance to use lower 60/40 rates in Section 1256(g)
“Forex” refers to the foreign exchange market where participants trade currencies, including spot, forwards or over-the-counter option contracts. In the forex industry and IRS content, it’s called the “Interbank” market. Forex differs from trading currency RFCs (regulated futures contracts) on futures exchanges. Like other RFCs, currency RFCs are Section 1256 contracts reported on Form 6781 with lower 60/40 capital gains tax treatment.
Forex tax treatment
By default, forex transactions start off receiving an ordinary gain or loss treatment, as dictated by Section 988 (foreign currency transactions). The good news is Section 988 ordinary losses offset ordinary income in full and are not subject to the dreaded $3,000 capital loss limitation — that’s a welcome relief for many new forex traders who have initial losses.
Section 988 allows investors and business traders — but not manufacturers — to internally file a contemporaneous “capital gains election” to opt-out of Section 988 into a capital gain or loss treatment. One reason to do so is if you need capital gains to use up capital loss carryovers, which otherwise may go wasted for years.
The capital gains election on forex forwards allows the trader to use Section 1256(g) treatment with lower 60/40 capital gains rates on major currencies if the trader doesn’t take or make delivery of the underlying currency. “Major currencies” means currencies for which currency RFCs trade on U.S. futures exchanges. There are lists of currency contracts including pairs that trade on U.S. futures exchanges available on the Internet. Section 1256(g) does not mention the inclusion of spot forex, so we make a case for including spot forex in Section 1256(g) in our blog post, A Case For Retail Forex Traders Using Section 1256(g) Lower 60/40 Tax Rates.
The “Tax Cut & Jobs Act” (Act)
The Act created a new 20% deduction on qualified business income (QBI) in pass-through entities. A forex trading company with trader tax status (TTS) is eligible for the QBI deduction as Section 988 ordinary income is includible in QBI for TTS traders. QBI excludes capital gains or investment-related Section 988 ordinary income. Trading is a specified service activity, so the 20% deduction is phased out above the taxable income threshold of $415,000 (married) and $207,500 (other taxpayers). A forex TTS trading company should weigh the opportunity for this deduction vs. the capital gains election and use of Section 1256(g) lower 60/40 tax rates. Consult with us about it.
Forex accounting and tax reporting
Summary reporting is used for forex trades, and most brokers offer good online tax reports. Spot forex brokers aren’t supposed to issue Form 1099Bs at tax time. Section 988 is realized gain or loss, whereas, with a capital gains election into Section 1256(g), mark-to-market (MTM) treatment should be used.
Section 988 transactions for investors are reported in summary form from gross income. Watch out for negative taxable income caused by forex losses without TTS; some of those losses may be wasted. (If you qualify for TTS, the negative income will likely generate a NOL.)
There are several nuances and complexities in forex tax treatment, accounting and tax compliance that you should know about. For example, forex brokers handle rollover interest and trades differently.
Spot vs. forwards
Most online trading platforms and brokers only offer forex spot contracts. These contracts clear within two days, whereas forex forward contracts clear in over two days. If a trader wants to stay in a spot trade longer than two days, the broker offers a “rollover trade” which technically is a realized sale and purchase of a new position (but not all brokers treat it that way). Forex spot traders don’t take delivery of the foreign exchange.
The Section 988 opt-out election
The election to opt out of Section 988 must be filed internally (meaning you don’t have to file an election statement with the IRS) on a contemporaneous basis (meaning the IRS does not allow hindsight). Section 988 talks about the election on every trade, but you can also make a “good to cancel” election which is more practical. The election can be made and withdrawn throughout the year.
For extensive content on forex tax treatment, accounting and reporting, read Green’s 2018 Trader Tax Guide.