The rule for tax on forex trades in the United States can be a complex affair as these transactions are subject to various tax rules codified under the Internal Revenue Code (IRC) and interpreted through Revenue Rulings by the Internal Revenue Service (IRS).
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Treatment of Certain Foreign Currency Transactions
If you trade in foreign currency, gains or losses on such trades are generally treated as ordinary income or loss and are reported on Form 1040 Schedule 1. This is as per IRC Section 988,
However, some traders may qualify to opt out of this ordinary income or loss treatment by making a capital gains election. With this election, the Section 988 ordinary gain or loss treatment is overridden, and the capital gains rules of IRC Section 1256 will apply instead.
To apply Section 1256 for forex trading, a trader must qualify as a “trader in securities,” and the trade must be made in a regulated futures contract market, among other requirements. Hence, not all forex trades can qualify for this treatment.
What is the 60/40 Rule of Tax on Forex Trade?
IRC Section 1256 provides beneficial tax treatment for certain financial transactions, including regulated futures contracts and foreign currency contracts. Here, 60% of gains or losses are treated as long-term gains or losses, and 40% as short-term.
The maximum tax rate on long-term capital gains is 20% (or 0% or 15%, depending on your income), whereas short-term capital gains are taxed at your ordinary income tax rate.
Special Rule for Spot Transactions Tax on Forex Trades
A key Revenue Ruling relevant to forex traders is Revenue Ruling 2008-5, which guides the tax treatment of “spot forex trades“. According to this ruling, if a forex spot transaction settles within two days, it can qualify as a Section 988 transaction.
A spot transaction in forex trading is a contract to buy or sell a certain amount of a foreign currency at the current market price, with the transaction settlement (i.e., the physical exchange of the currencies) taking place within a short period, typically two business days after the trade is executed. For example, if a U.S. company needed to purchase goods from a European supplier, they might enter a spot transaction to buy euros with U.S. dollars. If the current EUR/USD exchange rate is 1.20, and the company needed to pay €10,000 for the goods, they would use a spot transaction to buy €10,000 for $12,000 (10,000 * 1.20). The company would have the euros they need to pay their supplier two business days later.
How is Mark-to-Market Taxation Accounting Done?
Moreover, IRC Section 475 applies to traders who elect for mark-to-market (MTM) accounting. A forex trader with trader tax status (TTS), can make a Section 475 MTM election, which allows them to count all their trading gains and losses as ordinary gains and losses, not subject to the wash-sale loss adjustments. However, to qualify for TTS, a trader must satisfy certain conditions. These conditions usually involve the trading activity’s frequency, volume, and continuity, among other factors.
What is Mark-to-Market accounting?
Mark-to-market (MTM) is an accounting method that values an asset, portfolio or account at its current market price instead of an assumed book value. An asset’s mark-to-market value reveals how much a company gets if it sells it then. It gives an almost correct view of gain or loss at a particular time.
Overall, the tax on FOREX trades in the U.S. involves various IRC provisions and IRS Revenue Rulings. It is essential for traders to understand the tax implications of their trading activities and to seek the advice of tax professionals when necessary.
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