Ordinary gains or losses in Section 988 or elect capital gains for a chance to use lower 60/40 rates in Section 1256(g) on major pairs

Forex refers to the foreign exchange market (also known as the “interbank” market), where participants trade currencies, including spot, forwards, or over-the-counter (OTC) option contracts. Forex differs from trading currency-regulated futures contracts (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 receiving ordinary gain or loss treatment, as Section 988 (foreign currency transactions) dictates. The excellent news is that under Section 988, ordinary losses offset ordinary income in full and are not subject to the $3,000 capital loss limitation. That’s a welcome relief for many new forex traders who have initial losses and offset the losses against wages and other income.

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 capital gain or loss treatment. Generate 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 currency pairs if the trader doesn’t take or make delivery of the underlying currency. A major currency pair is a forex pair that also trades as a regulated futures contract on U.S. futures exchanges. There are lists of currency pairs that trade on U.S. futures exchanges available online (search FX products on CME).

Spot vs. forwards

Most online trading platforms and brokers only offer forex spot contracts. Because guidance from the IRS isn’t clear, most retail off-exchange forex traders are unsure how to handle spot forex. Our extensive work in this area has led us to believe that, in many cases, spot forex can be treated like forex forwards, qualifying for lower 60/40 tax rates in Section 1256(g) on major currency pairs only with the capital gains election. These tax rates may be desirable if you have significant trading gains on spot forex contracts. We lay out a case for Section 1256(g) treatment on spot forex transactions, with certain conditions and restrictions. It’s essential to use proper tax return footnote disclosure. 

If you would like more information, you can see Green’sTraderTax Guide Chapter 3, Tax Treatment of Financial Products.