Forex Demo Account

Disclaimer: this is not a tax or investment advice of any kind.  Its intent is only to provide general information about taxation of online trading.  Consult a professional when filing your forex tax.  Applicable to U.S. residents.

Online trading of currencies can be a very profitable venture, but there is a certain time of year when those profits don’t seem so appealing.  It’s tax time!  

Forex tax rules are convoluted to say the least. The main issue is whether your particular online trading transactions fall under the same tax rules as regular commodities (governed by Internal Revenue Code Section 1256) or under the special rules of IRC Section 988 (Treatment of Certain Foreign Currency Transactions).

By default, Section 1256 applies to professional traders dealing with “forward contracts”, as opposed to spot forex. Using capital gains IRS Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles), forex traders are allowed to get a preferential tax rate by splitting their capital gains on Schedule D with a 60/40 split. As a result, 60% of the capital gains are taxed at the rate for long-term capital gains, which is currently a low 15%, while the other 40% is taxed at the short-term capital gains rate, depending on the online trader’s tax bracket (can be up to 35%). The average rate that the forward contract trader can enjoy is thus reduced to 23%, or 12% less than the regular short-term rate.

The non-professional online forex trader using a retail platform for online trading is usually  dealing with spot forex, which normally falls under Section 988 providing for regular treatment of gains and losses.  Among other things, using Section 988 eliminates capital-loss limitations, so that ordinary losses can be fully used to offset any type of income.  Therefore, this section greatly benefits the losing traders – which includes most of the beginner online traders who don’t follow the rules of survival in online forex trading.

As a result of this conflict between IRC Sections, an online trader has some flexibility in taxation.  If you have made a loss for the year in spot forex, file it under Section 988 and use the loss to offset other income.  If you have made a significant gain, it may prove beneficial to consult a tax professional on the possibility of opting out of Section 988 and using Section 1256 instead for a reduction in tax.  This may or may not be possible depending on the exact instruments that you used in your online forex trading.