How to File Profits Generated Through Forex Trading

Forex trading profits are reported to the Internal Revenue Service in two different ways. IRS code Section 1256 treats Forex profits as either short-term or long-term capital gains. Under code Section 988, profits are treated as interest income and taxed at ordinary income tax rates. This duel classification system can result in a higher or lower tax bill depending on what type of currency pairs were traded.

Step 1

Gather your Forex brokerage statements and put them in calendar month order. Look for any trades you made that used your normal currency as one of the currency pairs. For example, if you use U.S. dollars in your daily transactions, that would be considered your normal currency. Any trades you made using U.S. dollars as one of the currency pairs would qualify as Section 1256 trades. Profits will be split 60/40 and treated as short-term or long-term capital gains.

Step 2

Find the trades you made that did not include your normal currency. These are classified as Section 988 trades. The profit does not enjoy the favorable capital treatment that Section 1256 trades enjoy. Section 988 Forex profit is treated as regular income and taxed at your individual tax rate.

Step 3

Report your Forex Section 1256 trades on IRS Form 6781. In Part I, on line 1, in column A, enter the currency pair you traded. In column B, enter the trade’s loss. In column C, enter the trade’s profit. On line 2, enter the total amounts for columns B and C. Combine columns B and C and enter the net amount on line 3. Complete lines 4, 5, and 6, and enter the net amount on line 7. Compute your short-term capital gain or loss by multiplying the total on line 7 by 60 percent.

Step 4

Enter that amount on line 8 and on Schedule D on the appropriate line and column. Now compute your long-term capital gain or loss by multiplying the total on line 7 by 40 percent. Enter that amount on line 9 and on Schedule D on the appropriate line and column. Report straddle trades in Part II and unrecognized trades in Part III. Refer to the form instructions as needed.

Step 5

Disclose your Section 988 Forex trades by listing each transaction, along with the resulting profit or loss, on a separate piece of paper. Report your total gain or loss on Form 1040, line 21. Attach to Form 1256 the paper showing your Section 988 transaction and file both documents with your income tax return.

Items you will need

  • Monthly Forex statements from your trading account

Tip

  • Trade Forex pairs that use your normal currency to take advantage of the favorable tax treatment that applies to such trades.

Warning

  • Forex brokers do not send 1099s detailing your Forex transactions. Keep precise records of your Forex trades to accurately report your gains and losses to the IRS.

Photo Credits

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