Although foreign currency or Forex trading has taken place around the world for thousands of years, the taxation thereof for U. This should not be a surprise since the U. At the present time, U. Unfortunately, the making of these elections is not well known in either the Forex trading community or among tax advisors. For example, did you know that an election has to be made by the close of the day on which a trade is made?
This article will outline the tax rules applicable to cash or spot foreign currency trading by individuals and investment funds. It will also discuss how to make the relevant elections in order to attain the lowest applicable tax rates for Forex gains. By way of background, the maximum marginal federal income tax rates applicable in the U. In addition to these basic rules, currency traders potentially subject to two special provisions of the Internal Revenue Code. This is one of the principal advantages of trading futures over stocks.
In addition to Section , Section of the Internal Revenue Code contains special rules governing the tax treatment of currency gains and losses. There is an exception to this rule, however. Section provides an exception for currency positions which are identified by election as excluded from Section ordinary income treatment. If proper identification and an election is made, gains and losses from currency trading will be treated as capital gains and losses. Moreover, to the extent that the currency pair traded is traded on a U.
This important since most cash or spot currency contracts settle in two days, but are typically terminated and rolled over daily thus preventing a long term holding period from ever developing. For forex tax information on Exchange Traded Notes, see discussion here. A capital gains election applies on a transaction-by-transaction basis. In order to make the election with respect to a particular transaction, the taxpayer must clearly identify each Forex transaction on its books and records on the date it is entered into.
While no specific language or account is necessary to identify the transaction, the method of identification must be consistently applied and must clearly identify the pertinent transaction as subject to the election. The verification statement attached to a tax return must set forth the following: In addition to any penalty that may otherwise apply, the IRS may invalidate any or all elections made during the taxable year if the taxpayer fails to verify each election, unless the failure was due to reasonable cause or bona fide mistake.
A taxpayer receives independent verification of the election if a the taxpayer establishes a separate account s with an unrelated broker s or dealer s through which all transactions to be independently verified are conducted and reported; b only transactions entered into on or after the date the taxpayer establishes such account may be recorded in the account, c transactions subject to the election are entered into such account on the date such transactions are entered into and d the broker or dealer provides the taxpayer a statement detailing the transactions conducted through such account and includes on such statement the following: Hence, if an election out of Section ordinary treatment is made and losses are incurred, then the taxpayer will be disadvantaged to the extent he or she does not have adequate capital gains from other sources to use the capital losses.
Unused capital losses carry-forward to future years. Thus, the election has its own risks since ordinary deductions can be used to offset ordinary income from other sources i. An qualifying fund election for any taxable year shall be made on or before the 1st day of such taxable year. Any such election shall apply to the taxable year for which made and all succeeding taxable years unless revoked with the consent of the IRS.
More recently, the IRS issued Notice regarding a foreign currency option transaction which appeared to confirm that foreign currency spot contracts are subject to the Section and Section taxation rules discussed herein.
Because trading by individuals and investment funds who are sensitive to the rate differentials between ordinary income and capital gains has only intensified in recent years, it appears that this area has largely been ignored by tax advisors and taxpayers alike. Since rollover interest represents interest earned where long the higher yielding currency or interest expense where short the higher yielding currency , these amounts are treated as ordinary interest income or expense and must be accounted for separately from currency trading gains and losses.
Note that investment interest expense for individuals who are not engaged in a trade or business of trading is subject to severe limits on deductibility under Section of the Internal Revenue Code. However, to the extent that interest is not separately debited or credited, but is embedded in a lower or higher spot contract price in the rollover contract, it is unclear whether interest income or expense is recognized.
This latter situation is similar to the manner in which interest is accounted for on foreign currency futures where interest income or expense is factored into the price of the futures contract and not separately accounted for or taxed. Any rollover interest income must be separately reported on Schedule B. In that case, the trader will need to compute this amount on his or her own.
Section of the Internal Revenue Code defines who is and is not a U. It is presently unclear whether a non-U. Many types of "portfolio interest" income are presently exempt from U. While complex, with a modicum of understanding of the rules, substantial tax advantages can be obtained. Click here to enter the Forex Learning Center and learn about Forex Trading, rollover interest, currency pairs, technical analysis, fundamental analysis, trading strategies and money management.
Taxation of Foreign Currency Trading Demystified Although foreign currency or Forex trading has taken place around the world for thousands of years, the taxation thereof for U. Forex Learning Center Click here to enter the Forex Learning Center and learn about Forex Trading, rollover interest, currency pairs, technical analysis, fundamental analysis, trading strategies and money management.More...