Investors can trade on the changes in foreign currency value through a FOREX account. Gains and losses between the currencies are tracked using a special figure called a “pip.” FOREX can be traded through short-term trades or long-term contracts, and the Internal Revenue Service offers two ways to claim FOREX gains and losses for tax treatment.
FOREX and Pips
In FOREX trading, currency is traded in pairs. Commonly traded currencies include the euro, the British pound, the Japanese yen and the American, Canadian and Australian dollars. FOREX trades can be made through a short-term “spot” trade or through longer-term futures contracts. A “pip” stands for price interest point and represents the change in the exchange rate between the pair of currencies. A pip is usually equal to 0.0001 percentage but can change depending upon the currency.
Finding Profits from Pips
The value of the pip in a FOREX trade depends upon the size of the trade, the currency pair being traded and the exchange rate. Take for example a $100,000 FOREX trade of U.S. (USD) and Canadian (CAD) dollars that closed at 20 pips with an exchange rate of 1.06 USD/CAN. To find the profit, first find the CAD pip total by multiplying 0.0001 with $100,000, producing 10 CAD pips. The CAD pips are divided by the exchange rate to give the USD pip, which in this case would be 9.43 USD pips. That figure is then multiplied by the total pip gain of 20, which in this case would produce a profit of $188.60 for this FOREX trade.
Spot FOREX Trade Taxes
By default, retail FOREX traders fall under Section 988, which covers short-term foreign exchange contracts like spot FOREX trades. Section 988 taxes FOREX gains and losses like ordinary income, which is at a higher rate than the capital gains tax for most earners. An advantage of Section 988 treatment is that any amount of ordinary income can be deducted as a loss, where only $3,000 in capital gains losses can be deducted. Section 988 gains or losses are reported on Form 6781.
Futures FOREX Trade Tax
An investor can elect to be taxed under Section 1256, which is primarily for futures contracts and will allow investors to claim some capital gains deductions on profit or losses. Gains on investments held for less than one year are considered ordinary income, while gains on investments held longer than one year are taxed at a lower rate of 15 percent in 2013. Section 1256 applies a 60/40 tax ratio on FOREX profits, with 60 percent being taxed as long-term capital gains and 40 percent taxed as short-term ordinary income. For the highest income bracket in 2013, this comes to a tax rate of about 28 percent, according to the Green Trader Tax website. Capital gains and losses are reported on IRS Forms 6781 and on Schedule D.
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