Tax Implications of FOREX

FOREX, or the foreign exchange market, refers to the trading of foreign securities. Individuals and business entities may engage in FOREX for a variety of reasons. Foreign exchange transactions may be necessary when a business or entity purchases goods or services from an overseas vendor or when traders purchase foreign currencies to speculate on price movements. In the U.S., taxation on these transactions can be complex.

General

Many self-employed individuals and businesses incur foreign exchange gains and losses in the course of ordinary transactions. For example, a U.S.-based fashion designer may have a euro-denominated bank account to facilitate payments to industry representatives in Paris or Milan. Because foreign exchange rates between the U.S. dollar and euro fluctuate, the U.S. dollar value of the euro-denominated bank account changes even if the U.S.-based fashion designer does not deposit or withdraw money from the account.

IRC 988

Internal Revenue Code (IRC) Section 988 was designed to deal with ordinary business transactions such as those of the U.S. fashion designer described above. Section 988 aggregates gains or losses from these transactions and treats the income or loss from these transactions as "ordinary" income or loss for tax purposes. Importantly, the income or loss needs to be considered "economically realized" before it is recognized. The definition of an economically realized transaction can be complex, although it generally involves a finalized transaction or project.

Other Transactions

Individuals and businesses holding foreign debt securities, such as bonds, may find themselves falling under the Section 988 rules. Typically, the regular income from a bond is realized as investment income, specifically interest income. Foreign debt securities may return two general types of income -- the regular interest derived from the cash flows of the debt security and a foreign exchange gain or loss portion of the income which may be taxed as ordinary income under Section 988.

Traders

Certain investors make their living through trading FOREX securities. These traders are classified by the Internal Revenue Service (IRS) as traders. Traders may qualify to opt out of treatment under Section 988 by making an election to be treated under Section 1256 of the IRC. Section 1256 forces traders to "market to market," or report the FOREX contract as if it was sold at year end, but allows traders to pay a preferential tax rate on gains.

Section 1256

FOREX traders and those who have qualifying foreign currency contracts report the gains and losses from these transactions to the IRS through Form 6781, Gains and Losses From Section 1256 Contracts and Straddles. Form 6781 allows FOREX traders to treat 60 percent of gain or loss as if it was long-term capital gains, subject to special, reduced tax rates. The other 40 percent of gain or loss is treated at short-term capital gain rates, equivalent to ordinary income.

References

• Green Company: Currency / FOREX and Tax Treatment
• Internal Revenue Service: Section 988 -- Treatment of Certain Foreign Currency Transactions
• Internal Revenue Service: Gains and Losses From Section 1256 Contracts and Straddles
• Boston College Law Review: Federal Income Tax Treatment of Commodity Transactions