Forex Taxation

First, a warning. This section is complex and will be confusing for those without a tax background. We have Certified Public Accountants familiar with the nuances of Forex transaction treatment to prepare all of our statements. As an investor, you receive a simple K-1 that requires no special familiarity with Forex taxation. This is not legal or tax advice and is for informational purposes only.

Article by Robert A. Green, CPA of GreenTraderTax CPAs.

Taxation of forex is confusing and uncertain in the tax code and that makes tax filings difficult for forex traders. The tax-problem is that some types of forex are treated as IRC 1256 contracts with lower 60/40 tax treatment and other types of forex are treated as IRC 988 foreign currency transactions with ordinary gain or loss treatment. Plus IRC 1256 and IRC 988 are dueling and conflicting tax code sections.

Traders prefer the best of all tax-worlds with ordinary tax treatment for losses, so they are exempt from capital loss limitations. And capital gains (60/40) tax-treatment for gains, so they save up to 12% in tax rates (23% versus 35% at current tax rates). Traders should learn the complex rules for forex taxation before they start trading forex so they can make the necessary elections in-advance to ensure the best overall tax treatment. Can forex traders have their (tax) cake and eat it too?

How are the different types of forex are taxed?

Currency futures and options listed on U.S. commodities and futures exchanges are by default treated as 1256 contracts. There is no confusion in the tax code about it and traders or investors get lower 60/40 tax-treatment by default.

But for these U.S. listed forex futures and options, few traders know they may also elect out of IRC 1256 for IRC 988 (foreign currency transaction) ordinary gain or loss treatment. But this is not a big problem in the real world since very few individual traders would want to exchange lower 60/40 tax-treatment for higher ordinary gain tax-treatment? This election is very strict and it must be made on January 1 or the start of trading later in the year, and once made can only be revoked with IRS consent.

You can’t cherry pick the election after-the-fact, when you know you have losses. This election is mostly used by corporations and hedgers to avoid capital loss treatment. Don’t panic about forex futures losses, IRC 1256 losses may be carried back 3 tax years; but only applied against IRC 1256 gains in those years.

Currency futures and options listed on foreign (not U.S.) exchanges are treated differently by default, but possibly in the same manner after doing some leg work. IRC 1256 contracts include not only contracts listed on U.S. exchanges but certain non-exchange traded contracts also. Two things can help you get foreign currency futures treated as IRC 1256 contracts.

First, we have argued recently that foreign futures are similar to U.S. futures and should be afforded IRC 1256 treatment. Otherwise, the U.S. may be in contravention of tax treaties with many other countries. Learn more in our recent articles on the subject in the February issue of SFO.

Second, in our below internal company tax memorandum on spot forex taxation, we argue that a trader or investor may elect out of IRC 988 for IRC 1256 on foreign currency futures listed on foreign exchanges. Therefore, we believe that like spot forex discussed below, you may claim IRC 1256 treatment on foreign currency futures listed on foreign exchanges, providing you also timely elect out of IRC 988.

Over-the-counter currency options are a huge marketplace. They are not futures or options contracts listed on U.S. or foreign exchanges; nor are they interbank-traded spot or forward currency contracts. OTC currency options are a breed apart and traded often by sophisticated traders. Even though the IRS never cleared up dueling and conflicting older tax law code sections IRC 1256 and IRC 988 in connection with spot forex taxation, the IRS did make the tax rules clear for OTC forex options in their 2003 tax notice (2003-81). In the notice, the IRS clearly states that OTC forex options are IRC 1256 contracts, but if you want 60/40 treatment, you still have to elect it.

Notice a trend developing here. IRC 1256 recognizes some foreign currency contracts as being 1256, while dueling IRC 988 also recognizes those same contracts as being IRC 988. Which tax code section wins and applies?

It’s reasonable to conclude that the trend shows you can claim 1256 treatment, but you should also elect out of IRC 988. Join the 60/40 lower tax club, but also get permission first to leave the higher-taxing IRC 988 club.

Interbank forex is the most confusing subject tax-wise. Read the below more in-depth articles and memorandum on the subject and next consult with a forex tax expert. Consider obtaining a tax opinion from GreenTraderLaw PLLC about how you report spot forex on your tax return. This may help you find the best tax outcome and also protect you from IRS penalties, if they disagree later on.

Here’s the skinny on IRC 988 foreign currency transactions. They are ordinary gain or losses reported in summary form on line 21 of Form 1040. Conversely, IRC 1256 foreign currency futures are reported on Form 6781; where they are split 60/40 before being moved over to Schedule D (Capital Gain or Losses).

IRC 988 interbank forex includes spot forex, forward forex and other types of forex contracts mentioned in the articles below. Spot forex differs from forward forex contracts in that spot settles in cash in no more than 2 days, and forward contracts settle in more than 2 days.

IRC 988 clearly states that a trader or investor (holding a capital asset versus a hedger or regular business) may elect out of IRC 988 for the more tax-beneficial IRC 1256 on forex forward contracts and foreign forex futures.

Here is where the big tax uncertainty comes into play. Notice that IRC 988 does not specifically mention that you may elect out of 988 on spot forex. This glaring omission unfortunately leads many tax professionals to shortsightedly concur that spot forex may only be treated with ordinary gain or loss treatment.

We argue that you can dig deeper to find a way to treat spot forex as IRC 1256, as long as you play it safe and also elect out of IRC 988 on spot forex too.

Here is how it works and how you can do it

Although it is not widely known by the forex trading marketplace, IRC 1256 recognizes many types of spot forex contract currencies as 1256 contracts. Read the below article and memo from GreenTraderLaw attorneys for the specifics here.

Again, the problem is that IRC 988 also specifically recognizes spot forex contracts as IRC 988 transactions. Again, these two tax code sections conflict and cause uncertainty and risk for return positions on spot forex.

Does IRC 988 trump 1256 or does IRC 1256 trump 988 or must they co-exit? The prudent answer seems to be they must co-exist.

If 1256 trumped 988 on spot forex, then spot forex would always be 1256 and you could not even elect out of 1256 for 988 as that is allowed for U.S. exchange listed currency futures and options only. So you would be stuck with 60/40 treatment, which is not good if you have large spot forex trading losses, as you would prefer ordinary loss treatment with IRC 988. Be careful what you wish for.

So it’s a good thing that our firm and consensus professionals believe that spot forex is IRC 988 by default (sort of trumping 1256), so you start with ordinary gain or loss treatment. We explain why we believe that spot forex is sufficiently similar to forward forex contracts so you can also elect out of 988 on spot forex too.

It seems like our logic on spot forex pays good dividends. You can argue that spot forex is 1256 as long as you elect out of 988 first. Have your cake and eat it too.

Again, tax law for forex is very confusing and complex and the only thing that is certain is that there are major conflicts in the tax code with IRC 1256 and IRC 988. GreenTraderLaw is attempting to work with the IRS to codify overdue guidance to clear up the confusion. We need support from sponsors and traders. Please ask your forex brokers to sponsor the GreenTrader Alliance for Traders to help. Please join the alliance as a member too.

A note of caution. You can have your cake and eat it too with ordinary loss treatment and 60/40 gain treatment by using internal elections wisely. But don’t fool around with making these elections. If you wind up with 60/40 treatment on gains and ordinary loss treatment on losses from year-to-year, that will appear to be “cherry picking” after-the-fact, even though the elections must be made in advance of trading.

We expect IRS clarification, but possibly also a requirement for external elections like with IRC 475 mark-to-market accounting for business traders.

If you have any questions, e-mail the Green Company at info@greencompany.com.