If you are wading into the currency market, keep in mind the federal tax rules on capital gains and the treatment of your trading results. This investment area is subject to complex tax regulation, which you can resolve only with good records and some early decision-making.
Long- and Short-Term Gains
A crucial consideration in forex taxation is the difference between long-term and short-term capital gains, as defined by the IRS. In general, long-term gains are those realized on investments held longer than a year; you take short-term gains (or losses) on investments that you hold for less than a year. The tax rules favor long-term gains, which are subject to a maximum tax rate of 15 percent, while short-term gains are taxed at a maximum of 35 percent.
If you are trading options and futures on currencies, you are speculating by buying and selling contracts, which have variable market prices and specified expiration dates. In Internal Revenue Service parlance, these are 1256(g) contracts, subject to a 60/40 split. The IRS taxes 60 percent of the gain as long-term, and 40 percent as short-term. In effect, the IRS blends these rates for any gains, taking into account the maximum tax rates for long- and short-term gains, and the result is a 23 percent rate on gains for all transactions no matter how long you hold them.
Spot currency traders buy and sell currency pairs, which rise and fall according to market demand for one currency versus another. Most spot trades open and close within two days, are categorized as “988” contracts by the IRS and are taxed at the short-term rate (maximum 35 percent). With spot trading, you can deduct all of your losses against your gains. This allows an advantage against other short-term investments, for which you can only deduct a maximum of $3,000 in losses.
The IRS allows you the option of treating your currency-trading gains under either 1256 or 988 rules, whether you deal in options, futures, or the spot market. You must make this election before the trading year begins on January 1. If you are a new trader, you can make the election at any time during the year, as long as it's before you begin trading. If your accountant or broker has designated either method, you can change that designation if you wish, but again, before January 1 or before you begin trading. Remember that the 1256 method taxes currency gains at a lower rate, but the 988 rule allows you to deduct all trading losses.
Without good records investment, taxation becomes quite a chore. Although you may be an active speculator who opens and closes several hundred trades during the year, you don’t need to keep track of every trade. The IRS allows you to submit a simple performance record for the year, which includes beginning and ending assets, deposits, withdrawals, interest income, and all trading and broker expenses. The result of this calculation is your net gain or loss.
- Hemera Technologies/AbleStock.com/Getty Images