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There are two types of foreign exchange trades: cash (or currency) forex trades on the unregulated interbank market, a network of government central banks, commercial and investment banks, while forex futures and options trade on regulated U.S. commodity markets and foreign exchanges.

Both types of forex, currency and futures, share the same goal: to capitalize on the natural fluctuations in foreign currency exchange rates around the world. But the Internal Revenue Service treats currency and futures trading quite differently when it comes time to split your earnings with the taxman.

Currency traders fall under the default special rules of IRC Section 988 (Treatment of Certain Foreign Currency Transactions). This section was originally created to tax companies on income they receive as a result of the fluctuations of foreign currency exchange rates during the normal course of business, such as buying foreign goods.

Under Section 988, gains or losses are reported as “other income” on Line 21 of Form 1040, where they are treated as interest income or expense and taxed at the ordinary income rate, currently 35%. Trades included under the 988 rules include spot forex (trades that settle in fewer than two days), forward forex (trades settling in more than two days) and several others.

Futures and options trades, by contrast, are considered IRC Section 1256 contracts and given the same advantageous capital gains split as commodity trades: 60% taxed at the lower long-term capital gains rate (currently 15%) and 40% taxed at the ordinary short-term capital gains rate of up to 35%. The combined rate of 23% adds up to a 12% savings over the Section 988 rules.

The Escape Clause
If you think the full-freight tax rate of Section 988 seems discriminatory and onerous to currency traders, you’ll be pleasantly surprised to find that the IRS agrees with you. The reason: currency traders consider their currency position part of their capital assets in the normal course of business. As a result, the IRS allows you to opt out of high-tax Section 988 altogether and have all your currency trades taxed at the more attractive 60/40 capital gains split enjoyed by commodity traders, regardless of settlement time.

How much can you save by opting out? If you’re married and file jointly, a currency trader with a net gain of $100,000 can save $6,000 in taxes with the more favorable 60/40 split.

There are two important caveats to consider however. First, if you elected the mark-to-market accounting method, you won’t be able to opt out of Section 988 and take the 60/40 split. That’s not always a bad thing, as we’ll see shortly. Second, you must opt out of Section 988 before making the trades. You need only do this “internally” in your books or business records, meaning you are not required to notify the IRS.

Why the internal-memo provision? The IRS doesn’t want you “cherry-picking” by opting out in years when you have gains and remaining with Section 988 in years when you want to avoid the capital loss limitation of $3,000 under Section 1256. However, the IRS has shown little interest to date in punishing currency traders who wait until year’s end to exercise their option.

Silver Lining for Loses
That’s right, currency traders who experience a losing year do have a silver lining by not opting out and remaining with Section 988 rules. Because your net loss is considered ordinary interest expense, it will offset any type of ordinary income. Under Section 1256 however, your capital loss would be subject to the $3,000 capital loss limitation and can only be carried back three years, where it can only be offset by Section 1256 gains.

When it comes to accounting, there is no question that futures traders have it far easier than currency traders. At the end of the year, futures traders receive an IRS Form 1099 from their brokerage firm with their aggregate profit or loss listed on Line 9. Since currency traders don’t receive 1099s, it is up to them to segregate their cash forex from other types of trading and report it correctly on their federal income tax return.

While it can be tempting for currency traders to simply lump their cash trades in with their Section 1256 activity, it’s not advised for several reasons: you would be disregarding the rules set forth by the Internal Revenue Service (for which you one day may have to answer), you could expose yourself to fines and penalties if you show a pattern of “cherry picking,” and in the case of losses you could be paying more tax than necessary.

Traders Accounting tax professionals can help you file your forex trading correctly and advise you on solutions to the accounting challenges that currency trading presents. Forex taxation is one of the most complicated and demanding sections of the tax code. Don’t let it catch you in its web - call Traders Accounting at 800-038-9513 today to take the worry out of tax time.

Section 1256: Lovable Tax Savings for Futures Traders. It’s not often in the complex world of trader tax accounting that we stumble upon an out-and-out gift from the Internal Revenue Service with no strings attached, but just such a friendly St. Bernard of a tax break may be found in Section 1256 contracts.

What is a 1256 contract? The IRS defines Section 1256 contracts as any regulated futures contract, foreign currency contract or non-equity option, including debt options, commodity futures options and broad-based stock index options.

By definition, these trades are marked to market on the last business day of the year in order to calculate capital gains or losses. Whether or not you have selected mark-to-market as your accounting method does not affect the 1256 status of these trades.