Last Updated: February 1, 2023
The first things that come to mind when talking about forex trading the profits and potential losses, as many mainly associate this practice with its short-term benefits. However, one thing all investors must be aware of upon entering the market are the forex trading taxes.
This article will cover the basics of forex taxes and explain the best way to file taxes obtained through forex trading. We’ll also provide information on how to keep track of your trading practices, and mention some key factors traders should keep in mind.
The Basics of Forex Trading Taxes
As we know, the primary goal of all traders in the forex exchange markets is to make successful trades and grow their accounts. However, before making their first move, investors should be aware of the tax implications of the forex market.
Forex is traded in two ways, either as cash forex on the unregulated interbank market that falls under the IRC Section 988 or as currency futures on the regulated exchange markets that fall under the IRC Section 1256.
Filing tax on forex trading under the former or latter comes with its perks and downsides based on your losses and gains and your particular tax bracket. However, before going into more detail, we should mention forex taxes are subject to 60/40 tax consideration, meaning 60% of losses and gains are treated as long-term, while 40% are considered short-term capital losses or gains.
Section 1256 Contracts
If you’re trading in futures currencies, your taxes fall under the 1256 section. In this case, investors are taxed on 60% of long-term capital gains or losses at a fixed 15% rate. This type of forex tax treatment is usually favorable for investors in the high income tax brackets (22% bracket or higher).
The proceeds of stocks traders sell within a year of their purchase are treated as short-term gains, and they’re always taxed at the same rate as the trader’s ordinary income. These make up the remaining 40%, and their tax ranges from 10% to 37%.
Section 998 Contracts
If an investor files their earnings under this section, they’ll be treated as ordinary income and taxed at a rate between 0% to 37%. The amount a forex trader will pay depends on their particular bracket. It’s important to note that if a trader’s only source of income is forex trading and their annual income isn’t above $12,400, they’re not obligated to pay tax on this amount.
Additionally, choosing to file your spot forex trading taxes under this section can be a great benefit if you experience net losses throughout the year, as all losses will be counted as ordinary losses, unlike in the 1256 contract.
|DID YOU KNOW: You can learn more about how the forex trading market works by keeping track of economic data, credit ratings, news reports, interest rate policies, and supply and demand trends.|
How to Avoid Tax When Trading Forex
Before we move on to discuss which contract can make a better option for investors, to avoid any confusion, we should mention futures traders are considered 1256 contracts, while over-the-counter (OTC) investors are considered 988 contracts.
When it comes to forex trading and taxes, many investors think they can get away with not paying taxes once they learn over-the-counter trading isn’t registered with the Commodities Futures Trading Commission (CFTC). However, these traders should be aware the IRS will catch up on this eventually, and the tax avoidance fees are bound to be much higher than the tax itself.
Choosing Between a 1256 or a 988 Contract
Another thing traders should keep in mind is that they must decide on which contract to use before the first day of the calendar year. Additionally, we must mention that compared to 1256 contracts, 988 contracts are much simpler, and their tax rate stays constant on both gains and losses, which makes them a better option for traders experiencing more frequent losses.
On the other hand, if we take into consideration how is forex taxed on 1256 contracts, although more complex, it can make a better option for investors who have net gains, as it offers 12% more savings in such a scenario.
As a rule of thumb, most brokerage firms prefer to offer 1256 contracts to futures traders and 988 contracts to spot traders. It’s always wise to consult an accountant before choosing an investing account, as opting out of an account can be a complicated process.
Upon anticipating net gains, many traders decide to opt out of their 988 status and transfer to a 1256 contract. When doing so, the trader must mark the change in their books and file it with their accountant. Ultimately, choosing which taxes on forex trading you’re willing to endure depends on your individual circumstances.
|DID YOU KNOW: If you’re wondering is investing a good idea, remember it’s recommended for financially stable individuals who already have double the amount they intend to spend.|
How to Keep Track of Your Performance
Keeping track of your performance is vital to any practice, and this is also true when it comes to forex trading and taxes. Although your brokerage statement will give you a general overview of your trading activities, your performance record can give you a more detailed layout of your gains and losses.
Here’s the record-keeping formula approved by the IRS:
- First, subtract your opening assets from your end assets.
- Then, subtract the cash deposits to your accounts and add the withdrawals.
- Next, subtract your income from interest and add paid interest.
- Include other trading-related expenses.
This performance record formula can provide traders with an accurate depiction of their profit/loss ratio, making the final tax filing easier.
Things to Remember When Paying Taxes on Forex Trading
Some of the things regarding the forex tax treatment that can make the process less difficult for traders include:
No matter whether you’re just about to enter the forex market or a more experienced trader, you should remember all traders are required to select their tax situation type before January 1.
Proper record keeping can save you a lot of time and worries during tax paying season. Having to spend less time on preparing taxes will give you more time to trade during this period.
Obey Tax Laws
As we mentioned previously, thinking you can get away with not paying taxes associated with over-the-counter trading can easily backfire. To avoid paying penalties on the taxes owed, be sure to pay your taxes on time.
|Forex taxes are subject to 60/40 tax consideration.|
|Future currency traders fall under the 1256 section, while over-the-counter traders are taxed under the 988 section.|
|Although over-the-counter trading isn’t registered with the Commodities Futures Trading Commission (CFTC), there’s no way to avoid taxes on forex trading.|
|The IRS-approved record-keeping formula can provide traders with an accurate description of their profit/loss ratio.|
|Traders are required to select a type of tax situation before January 1.|
Is Forex Trading Worth It?
Now that we’ve covered how forex trading taxes work in the US, we should also mention other factors that influence the trading experience. Although there’s no set amount on how much income forex trading can bring you, it’s widely considered a lucrative practice due to the fact your win rate largely depends on your chosen trading strategy and risk management.
What trades should also be aware of is that day-trading investors are more likely to have more expenses, as they often need access to quality investment tools to trade profitably. Although this increases their chances of profit, forex day trading taxes aren’t as favorable as those of long-term investing.
In some cases, day traders can apply for special day trader tax treatment offered by the IRS, which may reduce tax impact, but also make net profits subject to self-employment tax. All things considered, there’s no straightforward, right-or-wrong answer to whether forex trading is a profitable practice, as how much a trader makes depends on their decisions.
It goes without saying that failing to pay your taxes on time can bring you a lot of headaches. As we mentioned, there’s no use in looking for ways on how to avoid tax when trading forex, which is why understanding the tax process is crucial for all investors. By being aware of the benefits and downsides of using a 1256 or 988 contract, a trader can make a decision that aligns with their trading practices.
For futures traders under the 1256 section, 60% of long-term capital gains or losses are taxed at a fixed 15% rate, while the 40% short-term gains tax ranges from 10% to 37%. On the other hand, an investor who files under the 988 section will be taxed at a rate between 0% and 37%.
The best way to prepare for paying your tax on forex trading is by keeping track of your win/loss ratio. You can gather information on your trading practices from your brokerage statement, but for more accurate details, you can use the IRS record-keeping formula.
Forex trading taxes vary depending on the type of contract you opt for. As an investor with more net gains, you can secure 12% more savings by choosing a 1256 contract, while you should go for a 988 contract if you often face losses so your losses can be treated as ordinary income.