FOREX is short for foreign currency exchange. When you trade foreign currency and make a profit, your FOREX income must be reported to the Internal Revenue Service. However, FOREX earnings aren’t taxed like those of other securities such as gains on stocks or bond interest. FOREX income may be taxed two different ways – and you get to pick the one that suits you.
Section 988 Reporting
You can elect to have FOREX income taxed under Internal Revenue Code Section 988 or Section 1256. You must make your choice as of January 1 for the coming year or FOREX earnings automatically fall under S.988. The S.988 rules define all gains or losses from currency trading as ordinary income or losses. This means you report the income just as you would interest or dividends and pay ordinary tax rates. A loss can be taken as a deduction against ordinary income. There is no dollar limit for a loss deduction as is the case for capital losses.
Section 1256 Reporting
If you elect to report FOREX income under IRC S.1256, 60 percent of the income is treated as a long-term capital gain and taxed at a lower rate than ordinary income. The remaining 40 percent is considered ordinary income. If you make a profit trading FOREX in the coming year, IRC S.1256 tax reporting will result in a lower tax rate.