Lost in Translation: Foreign Exchange Tax Codes

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?

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

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.

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.

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.

Our lovable Beethoven-size tax break benefits commodities and forex traders in three ways:

1. The split: Instead of having all of your trading gains subject to the short-term capital gains tax rate of up to 35%, Section 1256 contracts allow 60% of your gain to be taxed at the lower long-term rate of 15%. This results in a combined tax rate of 23%, a 12% savings over the short-term capital gains rate.

2. The carry-back: Section 1256 losses can be carried back three years, rather than merely forward to the following year, as long as you obey the rules. For instance, you can only carry your loss back to years in which you had 1256 gains, and only 1256 gains can offset them. The loss is first carried back to the most recent qualifying year; after that, any remaining loss may be absorbed by the next two most recent years. As a result, you can amend previous years’ returns to include this year’s loss and possibly even receive a refund.

3. The tax preparation: Section 1256 affords forex futures traders a significant accounting advantage over forex currency traders, beginning with the Form 1099s you receive from your broker at year’s end (currency traders don’t get 1099s). On your 1099s, you just plug the aggregate profits or losses found on Line 9 into Part 1, Line 2 of IRS Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles) and the form does the 60/40 split for you: the 60% total to be taxed at the lower long-term rate winds up on Line 9, the 40% total to be taxed at the higher short-term rate can be found on Line 8. The two totals will eventually end up on Schedule D (Capital Gains and Losses): the 60% total on Part 2, Line 11, the 40% portion on Part 1, Line 4.

Currency Traders Can Cash In, Too

It’s little wonder that currency traders choose to opt out of their default Section 988, which taxes their gains or losses as interest income or expenses at the current tax rate of 35%. The catch is, they must opt out on a “contemporaneous basis,” meaning before making the trades, by noting their intention “internally” in their records.

Because there is no requirement to notify the IRS of your decision, some traders bend the rules and make their choice a more opportune time, such as the end of the year. However, should the IRS decide to crack down on abusers who “cherry-pick” their tax bracket, a shady track record could prove costly down the road.

Unfortunately, forex traders sometimes slip into bad tax habits. Some lump their currency activity in with their 1256 commodity trading at tax time, while others fail to opt out of their default Section 988 status and end up paying the highest tax rate on their trades. A Traders Accounting tax professional can help you set the optimum course for tax savings.

Our lovable tax break may be trader’s best friend, but in some instances it may be advantageous for currency traders to avoid the cuddly beast. As a general rule, if you have currency losses, you will typically improve your tax position by not opting out and instead remaining in Section 988. In this scenario, your ordinary losses could then be offset by any form of income rather than only Section 1256 income, and would not be subject to the $3,000 capital loss limitation and restricted to 1256 offsets.

Nothing about forex taxation is ever as simple as it may appear; each trader’s individual circumstances dictate a unique set of options to choose and courses to follow to arrive at their optimal tax position.

Trader’s Accounting’s tax professionals know the intricacies of the unique tax landscape that comes with your trader tax status. It’s not a place you want to navigate alone. Give us a call today at 800-938-9513 and let us help you discover the hidden tax savings you’ve been missing.