For beginners in the foreign exchange markets (FOREX), the goal is simply to make successful trades. In a market where profits and losses can be realized in the blink of an eye, many just want to try their hand before thinking long-term. Nevertheless, there’s good reason to consider the tax implications before making that first trade.
For Options and Futures Investors
This is a major benefit. In contrast, the proceeds of stocks sold within one year of their purchase are always taxed at the same rate as the investor’s ordinary income. When trading futures or options, investors are effectively taxed at a rate of 23%.
For Over-the-Counter (OTC) Investors
If you trade spot FOREX you will likely be grouped in this category as a “988 trader.” If you experience net losses through your year-end trading, being categorized as a “988 trader” is a substantial benefit. As in the 1,256 contract category, you can count all of your losses as “ordinary losses,” not just the first $3,000.
Which Contract to Choose
Now comes the tricky part: Deciding how to file taxes for your situation. While options or futures and OTC are grouped separately, the investor can pick either a 1256 or 988 contract.
The significant difference between the two is that of anticipated gains and losses. But you must decide which you will use by the first day of the calendar year.
IRC 988 contracts are simpler than IRC 1256 contracts. The tax rate remains constant for both gains and losses, an ideal situation for losses.
Notably, 1256 contracts, while more complex, offer 12% more savings for a trader with net gains.
Most accounting firms use 988 contracts if you are a spot trader and 1256 contracts if you are a futures trader. That’s why it’s important to talk with your accountant before investing. Once you begin trading, you cannot switch from one to the other.
Most traders naturally anticipate net gains, so they will want to elect out of their 988 status and into 1256 status. To opt out of a 988 status you need to make an internal note in your books as well as file the change with your accountant.
You can rely on your brokerage statements, but a more accurate and tax-friendly way of keeping track of profit and loss is through your performance record.
This is an IRS-approved formula for record keeping:
The performance record formula will give you a more accurate depiction of your profit/loss ratio and will make year-end filing easier for you and your accountant.
Things to Remember
When it comes to FOREX taxation there are a few things to keep in mind, including:
- Mind the deadline: In most cases, you are required to elect a type of tax situation by January 1. If you are a new trader, you can make this decision any time before your first trade.
- Keep good records: It will save you time when tax season approaches. That will give you more time to trade and less time to prepare your taxes.
- Pay what you owe: Some traders try to beat the system and don’t pay taxes on their FOREX trades. Since over-the-counter trading is not registered with the Commodities Futures Trading Commission (CFTC) some think they can get away with it. You should know that the IRS will catch up eventually and the tax avoidance fees will be greater than any taxes you owed.
The Bottom Line
Whether you are planning on making FOREX a career path or are simply interested in dabbling in it, taking the time to file correctly can save you hundreds if not thousands in taxes. It’s a part of the process that’s well worth the time.