Taking profits out of the FOREX markets requires a unique method of reporting and taxation that, at times, can differ significantly from the equities marketplace. Depending upon the specific types of contract you are trading within the FOREX marketplace, be it an options contract or an Over-The-Counter (OTC) contract, you will be required to use different methods of financial accounting when it comes time to report your annual investment gains. Knowing how to distinguish between these different reporting methods can save you time and money when tax season rolls around.
Regardless of the specific contract you are using for your FOREX trades, you will be required to report your earnings to the IRS on an annual basis. FOREX contracts and reporting requirements are governed by rules established in IRC Section 1256 and Section 988.
Understanding FOREX Contract Options
FOREX traders have the ability to trade two primary forms of contracts. FOREX options and futures contracts are commonly classified by the Internal Revenue Service as IRC Section 1256 contracts. Because of this, traders will receive a unique 60/40 tax consideration, which means that 60 percent of any gains or losses reported under Section 1256 will be considered long-term capital gains or losses, and 40 percent will be classified as short-term gains or losses.
This method of trading differs greatly from the standard OTC, which is classified by the IRS as a Section 988 contract. Here, investors will be required to report any losses or gains as they would with ordinary loss/gains accrued throughout the year. As a general rule, the FOREX marketplace considers an OTC contract to be any contract that is settled within 48 hours of its initiation.
Planning Your Tax Return
Although options trading and OTC contracts are considered unique from one another by the IRS, FOREX traders must complete the requisite paperwork for their yearly trading history and must decide which contracts are needed for their trades prior to Jan. 1 of the next calendar year. With that in mind, it is essential that FOREX traders keep a close log that accounts for each and every position they closed and took profits or losses from.
Keep in mind that, in similar fashion to equities trading, profit or loss from both OTC and options trading in FOREX only occurs if and only if a position is closed. Price swings that occur while a position remains open do not have influence on the final profit or loss that will be reported to the IRS.
Exploring Broker Resources
Fortunately, many of the online FOREX brokerage services in operation today provide traders with extensive documentation concerning their trade history and the paperwork they need to file the appropriate tax forms. As you begin the process of preparing your paperwork, make sure you review all of the fine details for both the 1256 and 988 options.
For example, a careful review of the 1256 form will reveal that this particular 60/40 tax split applies only to "major currencies," a term used to describe trading pairs that appear on U.S. futures exchanges. Details such as these will make the difference between a streamlined tax filing and major logistical problems.
Ryan Cockerham is a nationally recognized author specializing in all things business and finance. His work has served the business, nonprofit and political community. Ryan's work has been featured on PocketSense, Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.