[IMGCAP(1)]One of the most popular investment activities that has experienced dramatic growth in the past five years is retail foreign exchange trading.

 

This activity was once the sole province of large global banks, central banks, and other financial institutions due to large lot sizes of $1 million and average transaction amounts of $5 million. However, with the creative spirit of brokers to aggregate accounts, along with the advent of the Internet and sophisticated software trading platforms, the ability to trade foreign currencies was open for any consumer on the planet with the will, the capital, and a PC.

When the end of the year came around, most forex traders found themselves in a quandary as to how to prepare and report their various gains and losses from their trading activities. They quickly confronted an “unfriendly” IRS Tax Code that was extremely vague about treatment, tax rates, and where to enter anything on Form 1040. A majority of tax professionals were most likely confused as well since the language of the Tax Code had not kept up with the current state of affairs. Attempts to clarify some sections resulted in ambiguity in others. Matters have yet to be fully addressed, but weary traders have had to scan forex news and tax websites to do what is right.

The Tax Code assumes that trading in forex futures is similar to trading regulated futures contracts in the over-the-counter market. RFCs are not like securities where professional traders must treat everything as if it were ordinary income and expense related to a business activity. Forex futures contracts are accorded special treatment under Section 1256 where they receive a “60/40” split.

For example, 60 percent of the net gain for the year is treated as a long-term capital gain, and the remaining 40 percent as short-term capital gain. The rules apply equally to losses. Long-term capital gains are typically assessed at a lower rate of tax, such as 15 percent versus 35 percent at the high end of the ordinary income scale. These rates are scheduled to change in 2011 and do not include various state income tax burdens.

A subset of forex traders does trade forex futures contracts on the OTC exchange. However, most forex traders deal in the spot or cash forex market. To complicate matters, many traders transact business in both forex markets, including futures and spot. The RFC part of tax reporting is straightforward, although there was a move early in 2010 to eliminate the 60/40 split benefit, but it died in committee. This proposal will likely be raised again since the administration is searching for new tax revenue.

Brokers in the OTC space do provide 1099s at yearend with appropriate tax information. Spot forex brokers generally do not provide 1099s. By default, these gains fall under Section 988. In this code section, the gains and losses from forex are treated as interest revenue or expense, the net to be reported on Line 21 of Form 1040. Consequently, capital gains rules do not apply, the 60/40 split is not available for use, and unwary traders can expect to pay more if they do not know their rights.

Section 988 is further complicated by requirements to record currency value changes on a daily basis, but the IRS also permits a trader to opt out of these provisions. A forex trader may choose Section 1256 treatment for each separate transaction by opting out of Section 988 before each trade and maintaining personal records to support these elections. Most traders wait until yearend to make these decisions, but this bending of the rules will most likely draw IRS attention at some point.

The present situation is open to obvious manipulation and abuse. In order to minimize taxes, a taxpayer would only have to treat all losses as Section 988 to offset other ordinary income, and then treat all gains as Section 1256 to benefit from favorable capital gain treatment.

To complicate matters further, the IRS has provided Notice 2007-71, which states that “over-the-counter currency options” may no longer be treated as “foreign currency contracts” in Section 1256; instead they are now part of Section 988. Forex binary options have arrived on the scene in the past two years as if the IRS anticipated the arrival beforehand. An opt-out election exists for these, too.

Perhaps the IRS intended to clarify matters, but the 2007 notice and Sections 988 and 1256 remain conflicted and confusing as ever for most all forex traders and brokers.

The one positive point is that none of these revenue items are subject to self-employment taxes, a relief of sorts. However, forex traders would be wise to check with their tax professionals before filing their tax returns, especially regarding documentation for Line 21 items.

Vincenzo Desroches started a financial and forex journey as a young entrepreneur and through years of self-taught investment. However, his interest in economics has been a lifelong hobby, fulfilled through various books, magazines, and courses. He has added to his knowledge of international economics in business trips around the world including Europe, Asia and Africa. Currently, he is writing a small business book while continuing his exploration of economics together with all of his prodigious interests. Read more at http://www.ForexTraders.com.