Tax Consequences of Trading Currencies
As currency values fluctuate, currency traders can make a profit by predicting these fluctuations and buying and selling currencies accordingly. This type of trading is called foreign exchange, or forex. As with any investment income in the United States, the income traders make through currency transactions is taxable. Forex trading has specific taxation issues that traders should know about.
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Taxation Options
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When reporting their taxable income, forex traders may choose between two taxation options. The first is to report income according to the guidelines of Internal Revenue Code Section 988, which applies specifically to money from gains related to currency exchange. The second option is to report according to the guidelines of Internal Revenue Code Section 1256, which applies to capital gains in general. Capital gains are monies investors receive from the sale of assets. Forex traders may make this decision based on which is most beneficial for them.
Section 1256
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According to Section 1256, the IRS levies two capital gains tax rates--15 percent for long-term and 35 percent for short-term capital gains. Short-term assets are assets held by investors for less than a year. While stock market investors who have not held their stocks for at least a year must pay the 35 percent rate, forex traders do not have to pay the full 35 percent rate, regardless of how long they have held currency in a particular denomination. By reporting their income on IRS Form 6781, forex traders may pay the long-term rate on 60 percent of their gains and pay the short-term rate on 40 percent of gains.
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Section 988
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Unlike Section 1256, under Section 988, forex traders may have to pay the full 35 percent tax on their trading income. For this reason, most forex traders prefer to opt for taxation under Section 1256 rather than Section 988, which gives preferential treatment to forex traders who lose money on trades. While the IRS offers only limited tax advantages to investors who lose money on their investments under Section 1256, these limitations do not apply to Section 988. Put simply, successful forex traders benefit more from Section 1256, while unsuccessful forex traders benefit more from Section 988.
Opting for 1256
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Traders who wish to pay taxes according to Section 1256 do not need to submit any type of notice or application to the IRS. During an audit, however, they have to demonstrate their intent to report taxable income and pay taxes according to guidelines in Section 1256 rather than Section 988.
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References
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