For traders in foreign exchange, or forex, markets, the primary goal is simply to make successful trades and see the forex account grow. In a market where profits and losses can be realized in the blink of an eye, many just want to make money in the short-term without really thinking about the longer-term ramifications. Nevertheless, it usually makes some sense to consider the tax implications of buying and selling forex before making that first trade.
Forex Options and Futures Traders
For tax purposes, forex options and futures contracts are considered IRC Section 1256 contracts, which are subject to a 60/40 tax consideration. In other words, 60% of gains or losses are counted as long-term capital gains or losses, and the remaining 40% is counted as short term.
Key Takeaways
- Aspiring forex traders might want to consider tax implications before getting started.
- Forex futures and options are 1256 contracts and taxed using the 60/40 rule, with 60% of gains or losses treated as long-term capital gains and 40% as short-term.
- Spot forex traders are considered "988 traders" and can deduct all of their losses for the year.
- Currency traders in the spot forex market can choose to be taxed under the same tax rules as regular commodities 1256 contracts or under the special rules of IRC Section 988 for currencies.
A 60/40 tax treatment is often favorable for individuals in high income tax brackets. For example, the proceeds of stocks sold within one year of their purchase are considered short-term capital gains and are always taxed at the same rate as the investor's ordinary income, which can be as much as 37%. When trading futures or options, investors are effectively 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 of 37% (on the other 40%).
For Over-the-Counter (OTC) Investors
Most spot traders are taxed according to IRC Section 988 contracts, which are for foreign exchange transactions settled within two days, making them open to treatment as ordinary losses and gains. If you trade spot forex, you will likely be grouped in this category as a "988 trader." If you experience net losses through your year-end trading, being categorized as a "988 trader" is a substantial benefit. As in the 1,256 contract category, you can count all of your losses as "ordinary losses," not just the first $3,000.
Which Contract to Choose
Now comes the tricky part: Deciding how to file taxes for your situation. While options or futures and OTC are grouped separately, the investor can choose to trade as either 1256 or 988. Individuals must decide which to use by the first day of the calendar year.
IRC 988 contracts are simpler than IRC 1256 contracts. The tax rate remains constant for both gains and losses, which is better when the trader is reporting losses. Notably, 1256 contracts, while more complex, offer 12% more savings for a trader with net gains.
Most accounting firms use 988 contracts for spot traders and 1256 contracts for futures traders. That's why it's important to talk with your accountant before investing. Once you begin trading, you cannot switch from one to the other.
The rules outlined here apply to U.S. traders with accounts at U.S. brokerage firms.
Most traders naturally anticipate net gains, and often elect out of 988 status and into 1256 status. To opt out of a 988 status, you need to make an internal note in your books as well as file the change with your accountant. Complications can intensify if you trade stocks as well as currencies because equity transactions are taxed differently, making it more difficult to select 988 or 1256 contracts.
Keeping Track
You can rely on your brokerage statements, but a more accurate and tax-friendly way of keeping track of profit and loss is through your performance record.
This is an IRS-approved formula for record-keeping:
- Subtract your beginning assets from your end assets (net)
- Subtract cash deposits (to your accounts) and add withdrawals (from your accounts)
- Subtract income from interest and add interest paid
- Add in other trading expenses
The performance record formula will give you a more accurate depiction of your profit/loss ratio and will make year-end filing easier for you and your accountant.
Things to Remember
When it comes to forex taxation, there are a few things to keep in mind:
- Mind the deadline: In most cases, you are required to select a type of tax situation by Jan. 1. If you are a new trader, you can make this decision any time before your first trade.
- Keep good records: It will save you time when tax season approaches. That will give you more time to trade and less time to prepare your taxes.
- Pay what you owe: Some traders try to beat the system and don't pay taxes on their forex trades. Since over-the-counter trading is not registered with the Commodities Futures Trading Commission (CFTC), some think they can get away with it. You should know that the IRS will catch up eventually, and the tax avoidance fees will be greater than any taxes you owed.
The Bottom Line
Whether you are planning on making forex a career path or are simply interested in dabbling in it, taking the time to file correctly can save you hundreds if not thousands in taxes. It's a part of the process that's well worth the time.
FAQs
Forex Options and Futures Traders
These trades are subject to 60/40 tax consideration where 60% of gains and losses are eligible for long-term capital gains taxes while the remaining 40% is counted as short-term. Capital loss can be deducted from personal income tax using appropriate tax prep measures.
How do I avoid paying taxes on forex? ›
One of the most effective ways forex traders can avoid taxes is by trading through a tax-exempt entity. This could be a corporation, trust, or partnership that is set up specifically for the purpose of trading forex. By doing this, traders can avoid paying personal income taxes on their profits.
What happens if you don't pay taxes on forex? ›
If you fail to file your forex income, the Internal Revenue Service (IRS) could impose a penalty of up to 5% of the unpaid taxes for every month that the return is late, up to a maximum of 25%. The penalty could be higher if the IRS determines that you have acted negligently, intentionally, or fraudulently.
How much do forex day traders pay in taxes? ›
This is the most common way that forex traders file forex profits. Under this tax treatment, 60% of total capital gains are taxed at 15% and the remaining 40% of total capital gains are taxed at your current income tax bracket, which could currently be as high as 35%.
Is forex trading tax free in USA? ›
The answer is yes. Forex traders are required to pay tax on their profits. Forex trading is considered a business, so the profits from forex trading are taxable.
Is gain on forex taxable? ›
Foreign exchange gains and losses are taxable and deductible respectively if the gains and losses are: arising from revenue transactions; realised; arising from a trade.
Does forex report to IRS? ›
By default, Cash Forex is subject to IRC 988 rules with ordinary gain or (loss) treatment. However, if you are a trader, you can elect out of IRC 988. This will allow your gains to be treated as IRC 1256 with beneficial 60/40 capital gain treatment.
How do traders avoid taxes? ›
The first way day traders avoid taxes is by using the mark-to-market method. This method takes advantage of the ability of day traders to offset capital gains with capital losses. Investors can get a tax deduction for any investments they lost money on and use that to avoid or reduce capital gains tax.
How traders can save on taxes? ›
Utilize tax-advantaged accounts
If you trade options, you can do a variety of strategies in an IRA, for example, including buy calls and puts, sell covered calls, and more. Capital gains taxes can be deferred in IRAs and some other retirement accounts to help your money grow over time.
Do I have to pay taxes if I lost money trading? ›
Tax Loss Carryovers
If your net losses in your taxable investment accounts exceed your net gains for the year, you will have no reportable income from your security sales. You may then write off up to $3,000 worth of net losses against other forms of income such as wages or taxable dividends and interest for the year.
FX trading and gambling are different. Gambling is where the rules are against the gambler, and unlikely to make long-term profits. In forex trading, there are no rules against the trader preventing them from making long-term profits.
Can I claim forex losses on taxes? ›
If you have suffered forex losses, it is essential to report them accurately on your income tax return to avoid any legal issues. Keep accurate records of your transactions, calculate your losses, and report them on Form 8949. You can use your losses to offset your capital gains or other forms of income.
How do I report forex losses on TurboTax? ›
In this article, we will provide a step-by-step guide on how to report forex losses in TurboTax.
- Step 1: Gather Your Information. ...
- Step 2: Open TurboTax. ...
- Step 3: Enter Your Broker and Trading Information. ...
- Step 4: Enter Your Trading Activity. ...
- Step 5: Review and Submit. ...
- Step 6: File Your Taxes.
If you have gains from day trading activity, you may need to make estimated tax payments throughout the year to avoid tax penalties and interest charges.
What amount of crypto is taxable? ›
How much do you have to earn in crypto before you owe taxes? You owe taxes on any amount of profit or income, even $1. Crypto exchanges are required to report income of more than $600 for activities like staking, but you still are required to pay taxes on smaller amounts.
Does forex provide 1099? ›
Not all forex brokers are required to send out 1099 forms to their traders. The IRS requires brokers to send out 1099 forms only if the trader has made more than $600 in profits during the tax year. This means that if a trader makes less than $600 in profits, the broker is not required to send out a 1099 form.
How much taxes do traders pay? ›
Depending on your tax bracket, short-term capital gains are taxed at 10% – 37%. Long-term capital gains are profits you collected after selling an investment you held for over a year. These are taxed at a lower rate of 0% – 20% depending on your income.
Can you make a living off forex? ›
Forex trading may make you rich if you are a hedge fund with deep pockets or an unusually skilled currency trader. But for the average retail trader, rather than being an easy road to riches, forex trading can be a rocky highway to enormous losses and potential penury.
How much taxes do you pay on trading? ›
Generally, any profit you make on the sale of a stock is taxable at either 0%, 15% or 20% if you held the shares for more than a year, or at your ordinary tax rate if you held the shares for a year or less.
