How Forex Trades Are Taxed in the USA

6 Min Read
Last Updated July 23rd 2021

When it comes to forex trading, most people only think of how to make profits and how to grow your forex account further. They are aware profits and losses are part of the deal, especially because the equations can change in the blink of an eye, resulting in either.

Even though forex trading is an art to be perfected over a long time, at the outset, very few people think beyond short-term benefits. However, a successful forex trader is not only one who makes his account grow but also thinks about long-term consequences – taxes being one of them.  

Taxes on Forex Options and Futures Traders

Forex options and futures contracts are considered IRC Section 1256 contracts for tax purposes. As such, they are subject to a 60/40 tax consideration. It means that 60% of your gains or losses will be counted as long-term capital gains or losses while the remaining 40% will be counted as short-term gains or losses.

Important points to remember:

  • Aspiring forex traders should consider tax implications before getting started on trading
  • Forex futures and options are 1256 contracts and will be taxed according to the 60/40 rule. 60% of gains or losses will be treated as long-term capital gains and the remaining 40% as short-term.
  • Spot forex traders are considered 988 traders and can deduct their losses
  • Currency traders in the spot forex market can choose between regular commodities 1256 contracts and the special rules of IRC Section 988 for currencies

With these pointers, it is also important to understand that a 60/40 tax treatment is usually favourable for people in high-income tax brackets. While trading futures or options, investors are taxed at the maximum long-term capital gains rate, (or 20% on 60% of the gains or losses) and the maximum short-term capital gains rate (or 37% on the 40%).

Tax calculation for over the counter (OTC) investors

Most spot forex traders are taxed as IRC Section 988 contracts. These are for foreign exchange transactions settled inside two days, thereby making it possible to treat them as ordinary losses and gains.

If you are a spot forex trader, you are likely to be grouped in this category as a 988 trader. So, if you end up with net losses through your year-end trading as a 988 trader, you can get substantial benefits. It means that as in the 1256 contract category, you can consider all your losses as ordinary losses, and not just the first $3,000.

How to Choose the Contract?

Deciding how to file taxes for your situation is the trickiest part of tax calculation for forex traders. Options or futures and OTC are grouped separately. But an investor can choose to trade as either 1256 or 988. The only catch is that you must decide which to use by the first day of the calendar year.

It would be interesting to know that IRC 988 contracts are simpler than IRC 1256 contracts. Also, the tax rate stays constant for both gains and losses, which is better when the trader has losses to report. However, you should also be aware that the 1256 contracts, although more complex, offer 12% more savings if a trader has net gains.

Generally, most accounting firms prefer to use 988 contracts for spot traders and 1256 contracts for futures traders. In this scenario, you must talk with your accountant before you invest in forex trading. Once you start trading, you will not be able to switch from one contract to the other.

It is a common practice among the traders to elect out of 988 status and into 1256 status in anticipation of net gains. It is possible to opt-out of a 988 status. But if you do so, you must make a note in your books and also file the change with your accountant. Also, things might get a bit complex if you trade stocks along with currencies as equity transactions are taxed differently. It would make it even more difficult to choose between 988 and 1256 contracts.

How to Keep Track?

One of the most common means to track profit and loss is your brokerage statement. However, your performance record will give you an accurate and tax-friendly way to track your profit and loss. You can use the following IRS-approved formula for record-keeping:

  • Deduct your opening assets from your end assets
  • Deduct cash deposits to your accounts and add withdrawals from your accounts
  • Deduct income from interest and add the interest paid
  • Add any other trading expenses

With the above formula, you can arrive at your performance record. As you can see, it will give you an accurate picture of your profit/loss ratio thereby making the year-end tax filing easier.

Key Points to Note

There are few things you should always remember when it comes to forex taxation. They are:

  • Note the deadline - In most cases, you must select a type of tax situation latest by January 1 each year. If you are new to forex trading, you can make this decision any time before you do your first trade.
  • Good record keeping - Good record-keeping will save you loads of time during the tax season. It means that you can invest your time in trade and not running around getting your papers in order.
  • Pay up - Some traders try to be smart and beat the system by not paying taxes on their forex trades. They think they can get away with it as over-the-counter trading is not registered with the Commodities Futures Trading Commission (CFTC). However, you should know better and pay your tax dues on time. Even if you think you can get away with it, the truth is that the IRS will catch up eventually, and you will end up paying heftier penalties than any taxes you owed.

Conclusion

Whether you plan to make forex trading your career or are simply in it to dabble a bit, take the time to file your taxes correctly. It will not only save you hundreds, if not thousands, in penalties. You must pay the taxes and the process is well worth the time.

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