For beginner forex traders, the goal is simply to make successful trades. In a market where profits - and losses - can be realized in the blink of an eye, many investors get involved to "try their hand" before thinking long term. However, whether you are planning on making forex a career path or are interested in seeing how your strategy pans out, there are tremendous tax benefits you should consider before your first trade.
SEE: Forex Walkthrough
While trading forex can be a confusing field to master, filing taxes in the U.S. for your profit/loss ratio can be reminiscent of the Wild West. Here is a break down of what you should know.
For Options and Futures InvestorsFor anyone who wants to get started in forex options and/or futures are grouped in what are known as IRC 1256 contracts. These IRS-sanctioned contracts mean traders get a lower 60/40 tax consideration. What this means is 60% of gains or losses are counted as long-term capital gains/losses and the remaining 40% as short term.
The two main benefits of this tax treatment are:
Time Many forex futures/options traders make several transactions per day. Of these trades, up to 60% can be counted as long-term capital gains/losses.
Tax Rate When trading stocks (held less than one year), investors are taxed at the 35% short-term rate. When trading futures or options, investors are taxed at a 23% rate (calculated as 60% long-term times 15% max rate plus 40% short-term rate times 35% max rate).
For Over-the-Counter (OTC) InvestorsMost spot traders are taxed according to IRC 988 contracts. These contracts are for foreign exchange transactions settled within two days, making them open to ordinary gains and losses as reported to the IRS. If you trade spot forex you will likely automatically be grouped in this category.
The main benefit of this tax treatment is loss protection. If you experience net losses through your year-end trading, being categorized as a "988 trader" serves as a large benefit. As in the 1256 contract, you can count all of your losses as "ordinary losses" instead of just the first $3,000.
Comparing the TwoIRC 988 contracts are simpler than IRC 1256 contracts in that the tax rate remains constant for both gains and losses - an ideal situation for losses. 1256 contracts, while more complex, offer more savings for a trader with net gains - 12% more. The most significant difference between the two is that of anticipated gains and losses.
The Solution: Choosing Your Category CarefullyNow comes the tricky part: deciding how to file taxes for your situation. What makes foreign-exchange filing confusing is that while options/futures and OTC are grouped separately, you as the investor can pick either a 1256 or 988 contract. The tricky part is that you have to decide before January 1 of the trading year.