Lost in Translation: Foreign Exchange Tax Codes

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Jim Crimmins

05 Mar, 2007

in Forex and 1 more

Remember that hit movie “Lost in Translation,” in which a clueless Bill Murray wanders dumbstruck through the foreign and thoroughly baffling world of modern-day Tokyo? That’s the look that comes over many forex traders when they try to get their head around the Internal Revenue Code as it relates to foreign exchange trading.

Forex is the world’s largest and most liquid market, with a daily currency dollar volume of more than $1.4 trillion. Once primarily traded by banks and other financial institutions, forex opened to individual traders in the mid-1980s and became widely popular when trading exploded in the nineties. Forex can be lucrative indeed for traders who know how to capitalize on the rise and fall of various currencies.

Forex is traded in two ways: as cash forex, which trades on the unregulated interbank market, and as currency futures, which trade on regulated commodities exchanges. Here we refer to cash forex traders as currency traders and currency futures traders as futures traders for simplification. Of course, many forex traders are active in both markets.

Just as Bill Murray was lost in translation between two languages and cultures, forex traders encounter two completely different and contradictory Internal Revenue codes when tax time rolls around. Currency trades fall under the special rules of IRC Section 988 (Treatment of Certain Foreign Currency Transactions), while futures receive a considerable tax break under IRC Section 1256, which also governs commodities contracts.

To further confuse an already murky situation, under certain circumstances you are allowed to opt out of Section 988 and into Section 1256 - but you’re prohibited from doing so after the fact (i.e., at year’s end) simply to improve your tax position.

Because currency and futures are subject to different tax and accounting rules, it is important for forex traders to know into which category each of their trades fall so that each trade can be reported correctly to receive optimum tax advantage.

Feeling lost yet? When entering the foreign world of forex taxation, it’s a good idea to have a Traders Accounting tax professional at your side to avoid getting lost in translation.

Section 988 Pays Full Freight
Section 988 was designed to capture tax payments from companies that earn income from fluctuations in foreign currency exchange rates during the normal course of business, as with the purchase of foreign goods. What this means for currency traders is that all gains and losses are reported and taxed as ordinary income or loss, at the current rate of 35%. (Since futures traders do not trade in actual currencies, they do not fall under the 988 special rules.)

But because currency traders consider these fluctuations part of their capital assets in the normal course of business, the IRS enables them to opt out of Section 988, and thereby take advantage of the more favorable Section 1256 tax rules.

Section 1256: A Better Tax Mix
Why would you want to opt out of Section 988? Lower taxes on gains, of course.

Futures traders are allowed to split their capital gains, with 60% taxed at the lower long-term capital gains rate (currently 15%) and 40% at the ordinary (or short-term capital gains) rate of up to 35%. That combined rate of 23% amounts to a 12% tax advantage over the ordinary (or short-term) rate that currency traders face.

Currency traders with gains tend to opt out of Section 988 in order to take advantage of the 60/40 capital gains split and reduce their tax burden by 12%. But currency traders with losses may prefer to remain under Section 988, where their loss will be treated at the higher ordinary income rate of 35% rather than the lower Section 1256 split.

Of course, there’s a fairly significant catch: in order to opt out of the full-freight 988 rate, you must note your intention to do so before making the trades. The IRS doesn’t require you to notify them; you must only note your intentions “internally” to switch your currency trades to the 60/40 capital gains tax rate.

While the IRS has shown little inclination so far to crack down year to year on traders who may bend the rules and wait until year’s end to make up their minds, they would likely not hesitate to flag a trader whose opting has resulted in years of “cherry-picking” at the tax collector’s expense.

The increased popularity of forex trading will almost certainly lead to clearer delineation of these two contradictory tax codes and greater scrutiny by the IRS of those traders who may wander into trouble, lost in translation

Don’t get lost this tax season - get help. Our experienced Traders Accounting tax professionals can help you file your forex income correctly and in full compliance with IRS rules. We’re not just accountants, we’re traders, too. We can help you locate the maximum tax advantages available to you.

Section 988: Worst Case for Gains, Best Case for Losses. The world ’round, life seems to come in twos: Heads and tails. Regular and premium. Standard and deluxe. Coach and first class. Gold and platinum.

The same is true when it comes to forex trading and the tax rules that pertain to it.

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