Cash ForEx Taxes Can Be A Pain

Update: So I'm doing what I did last year, putting on Line 21 of the 1040
OTHER INCOME: Cash Forex
Then I enter a negative amount to indicate losses.

I spent the weekend working on my taxes. Complicated by the fact that I invested in a number of foreign exchange currency transactions. Basically currency futures.

Unless you're really good, and I mean really good I don't recommend it for anyone. It is too damn easy to lose money fast. It's actually possible to setup a demo account and trade pretend money to see if you like it. Again. I do not recommend you do this unless you're good. And by good I mean that you are trading 100,000 lots consistently and making money. The demos I've looked at will allow you to trade 1,000,000 lots but the leverage you need to do that is at least $10,000 up front of real money. The 1,000,000 makes your profits look outrageous. Don't fool yourself though. The losses can be equally outrageous.

If, and that is a big IF you are making money on the 100,000 or mini demos than I'd say go ahead and try it. Bear in mind that you will be filling tax paperwork. This is where it gets complicated. You can either declare yourself under 'trader status' or you can file the gains/losses against your regular income.

I will list some of the resources I use here. Look for updates later this week.

My advice now is that if you are unsure of the long term value of the dollar to look into a foreign currency denominated account like the admirably written daily pfennig discusses. This removes much of the risk associated with short term fluctuations. But allows you to take a safe long term position you won't be cashed out of due to stops or margin. If the euro dips to 1.26 range I'd say buy in. We'll see the top side of 1.5 in a year or so. This is my opinion. Take it for that.

ForEx trading is risky and a headache on your taxes as I said, this is some of the documentation I've found:

To “elect out” of IRC 988 or not, that’s the question
If you have cash forex trading gains, you will prefer to elect out of IRC 988, to benefit from up to 12% lower tax rates on Section 1256 contracts.
Conversely, if you have cash forex trading losses, you may prefer ordinary loss treatment over Section 1256 capital loss treatment, so you may not want to elect out of IRC 988.
Note that IRC 1256 losses may be carried back up to three tax years, but only against IRC 1256 gains in the prior three tax years. Ordinary losses may offset any type of income.
But, technically, it’s not a simple choice like this at the end of the year.
The rules require that you elect out of IRC 988 on a “contemporaneous basis.” This means that hindsight is not allowed and you must make your decision in advance of the trades’; before you know if you will have gains or losses. Can you bend the rules?
The election out of IRC 988 should be filed “internally”, which means you place it in your own books and records, as opposed to filing it with the IRS.

My opinion on 'electing out' means filing your intent in a sealed letter to yourself that you then post to yourself and never open that letter unless you are audited.

See also:

Futures and Cash Forex

Section 988 was enacted as a way for the IRS to tax companies that earn income from fluctuations in foreign currency exchange rates as part of their normal course of business, such as buying foreign goods. Under this section, such gains or losses are reported and treated as interest income or expense for tax purposes, and do not receive the favorable 60/40 split.

Because forex futures do not trade in actual currencies, they do not fall under the special rules of Section 988. But as a currency trader, you are exposed daily to currency rate fluctuations, hence your trading activity would fall under the Section 988 provisions.

But because currency traders consider these fluctuations part of their capital assets in the normal course of business, the IRS enables you to opt out of Section 988, and thereby retain the favorable 60/40 split for these gains under Section 1256.

Forex Taxes

Many currency traders bend the rules by waiting after the year is over to see if they have any gains from their trading activities. If they do, they claim that they elected out of IRC 988 to enjoy the beneficial Section 1256 treatment. On the other hand, if the sum of the trades from cash forex is not positive, they stick with the traditional Section 988. Since (under the current tax law) it becomes very difficult to disprove whether the trader made the election at the beginning or at the end of the year, IRS has not yet begun to crack down on this activity.

This information is for educational purposes only and should not be construed as tax or investment advice of any kind. Make sure that you consult with a tax professional about your forex taxes.