How to File Profits Generated Through Forex Trading

Profits earned from forex trading must be disclosed on a tax return.
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If you're a forex trader, any profits earned through your currency trading must be reported on your tax return. Forex trade profits can be reported under two sections of the IRS code, Section 1256 or Section 988. Under Section 1256, profits from foreign currency trading are split between short-term and long-term capital gains. Profits categorized under Section 988 are regarded as interest revenue and taxed as ordinary income. Profits categorized under Section 1256 may pay a lower tax than those categorized under Section 988.

Step 1

Determine if any of your forex trade profits fall under Section 1256. Section 1256 considers any foreign exchange contract a “Section 1256 contract.” Gains from foreign exchange categorized under Section 1256 are split 60/40 and tend to incur a lower tax expense than gains categorized under Section 988.

Step 2

Determine if any of your forex trade profits fall under Section 988. The sale of “non-functional currency" -- a currency that is not normally used by the seller -- that results in a capital gain can be regarded as a Section 988 gain. One hundred percent of Section 988 gains are taxed and reported as ordinary gains and are subject to ordinary tax rates.

Step 3

Fill out IRS Form 6781 for profits categorized under Section 1256. Sixty percent of the foreign exchange capital gains are taxed at the lower long-term capital gain tax rate of 15 percent. The remaining 40 percent of capital gains are reported as short-term and taxed as ordinary income; tax rates for this portion can reach as high as 35 percent. Schedule D of IRS Form 1040 also discloses the 60/40 split between foreign exchange capital gains. If Section 988 transactions are also Section 1256 gains, disclose these gains on Form 6781.

Step 4

Attach to IRS Form 6781 a list of any foreign exchange contracts that fall under section 988. Foreign currency contracts categorized under Section 988 are listed in a separate attachment to IRS Form 6781, with any applicable gains or losses disclosed.

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