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 considered 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 good news is 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. This is a way to 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. The definition of 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. If you have significant trading gains on spot forex contracts, these tax rates may be very desirable. We layout a case for Section 1256(g) treatment on spot forex transactions, with certain conditions and restrictions. It’s important to use proper tax return footnote disclosure.

We’ve learned from discussions with the IRS Chief Counsel’s office on forex taxation that the authors of Section 988 never contemplated retail trading in spot forex transactions. IRS attorneys figured the spot forex marketplace was for corporations to exchange currency in the ordinary course of their trade or business. Those transactions would be the ordinary gain or loss per Section 988. Manufacturers and other global businesses transact in the Interbank market (to hedge and exchange currency). Why would they want to file a capital gains election to opt-out of Section 988? Only traders or investors holding forex as a capital asset can file that capital gains election per Section 988.

IRS attorneys understood that professional forex traders were trading forex forwards, and there was a clear pathway into Section 1256(g). Also, spot forex isn’t mentioned in Section 1256(g). That makes sense since retail spot forex trading began around 2000, whereas Section 1256(g) was added around 1986.

To gain entry into Section 1256(g), the IRS requires that spot forex settle in cash and be traded in the Interbank marketplace, but it’s debatable what constitutes this marketplace. Please read our blog post, A Case For Retail Forex Traders Using Section 1256(g) Lower 60/40 Tax Rates.

For more information, see Green’s Trader Tax Guide