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 off receiving ordinary gain or loss treatment, as dictated by Section 988 (foreign currency transactions). The excellent news is that 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 wage 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 on the Internet (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. (See blog post referenced below.)

Forex tax reporting. Brokers provide details and summary reporting for forex trades, and most offer helpful online tax reports. Spot forex brokers aren’t supposed to issue Form 1099-Bs at tax time. Section 988 is realized gain or loss, whereas, with a capital gains election on major pairs into Section 1256(g), MTM treatment should be used.

Section 988 transactions for investors are reported in summary form on line 8(z), “other income or loss” of 2022 Schedule 1 (Form 1040). Watch out for negative taxable income caused by forex losses without TTS; you might waste some losses. (TTS forex traders use Form 4797 Part II instead, and the negative income may generate an NOL carryover depending on the taxpayer’s income from other sources.) Section 1256(g) treatment uses Form 6781, just like other Section 1256 contracts.

The Section 988 opt-out election. Make the Section 988 opt-out election by filing it 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 — the election is effective from the date made going forward). Section 988 talks about the election on every trade, but you can also make a “good to cancel” election, which is more practical. You can make the election and withdraw it throughout the year.

A word of caution: Forex trading losses can become wasted for non-TTS traders who don’t elect out of Section 988 and have negative taxable income. Forex losses become a part of NOL for those who qualify for TTS, but investors don’t have NOL treatment. Investors with no other source of income may be better off electing out of Section 988, so their forex losses can be classified as capital-loss carryovers and not wasted forever. Remember, the effective date of the election is as of the date made and going forward.

For more information, see Green’s Trader Tax Guide