How Do Forex Taxes Work?

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Contributor, Benzinga
January 23, 2024

As Benjamin Franklin, a founding father of the United States, once said, “In this world, nothing is certain, except death and taxes.”

While death happens once, paying the taxes is an annual event that ranges from slightly inconvenient to straight-out terrifying. Like everyone else, forex traders have to pay their taxes. This article will look through the options and provide tips for dealing with forex taxes.

Disclosure: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 69% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Types of Tax Reports for Forex Transactions

Forex traders face different tax requirements depending on various factors, including how you are executing trades. Here is how forex is taxed.

Forex Options and Futures Traders

Forex options and futures contracts fall within Internal Revenue Code (IRC) Section 1256. These trades are subject to 60/40 tax consideration where 60% of gains and losses are eligible for long-term capital gains taxes while the remaining 40% is counted as short-term. Capital loss can be deducted from personal income tax using appropriate tax prep measures.

The short-term taxation rate caps at 37%, so these derivatives are favorable for high-income investors because they lower the average taxation rate. The maximum long-term capital gains tax rate is 20%.

Understanding Capital Gain Tax

Capital Gains Tax refers to a tax levied on the profits made from the sale or disposal of certain assets, such as forex, stocks, real estate, or other investments. When an individual or business sells an asset at a higher price than it was initially purchased for, the difference between the purchase price and the selling price is considered a capital gain. This gain is subject to taxation by the government in order to generate revenue. The specific tax rate and rules regarding capital gains tax can vary depending on the jurisdiction and the type of asset being sold.

Over-the-Counter Investors

Trading OTC or spot forex market is not as favorable for wealthy investors, but it does come with some perks. These traders are taxed according to IRC Section 988 and treated as ordinary income or loss. However, they’re less complicated, and if a 988 trader experiences a net loss, it is not subject to a $3,000 capital loss limitation — it can offset ordinary income in full.

Deciding How to File Forex Taxes

Individual investors should decide whether to trade under IRC 1256 or 988 by the first day of the calendar year. IRC 988 is simpler to handle and more beneficial for traders who experience a loss — thus, it is more beginner-friendly because new traders often experience some losses.

On the other hand, IRC 1256 offers a 12% lower taxation rate for traders with net gains, making it more valuable for high-net-worth individuals.

Although more complicated, those investors likely have accountants doing their taxes, mitigating that downside.

Tax Rates and How Much You May Pay in Taxes

The taxation system in the U.S. can be fairly complex even without split classifications like the 60/40. For spot forex investors, their tax bracket dictates how much they pay in taxes, and while forex profits add to their winnings — they can also deduct their losses, pushing them into a lower tax bracket. Federal tax brackets range from 10% for earnings up to $10,275 to 37% for single filers earning $539,900 or more.

The situation is very different for non-U.S. citizens abroad, as it immensely varies by location. Some countries have no capital or even personal income taxes. These include havens like the Bahamas, Cayman Islands or the United Arab Emirates. Others have a separate capital gain tax rate, such as Greece at 15% or Switzerland 0%.

Furthermore, there are special considerations. For example, the U.K. has a 20% capital gain tax on all gains except residential property. However, traders have a way around this by using 0% tax rate spread betting. This way, they’re not purchasing an underlying asset (currency) but instead betting on its movement through a broker who manages the risk on their balance sheet.

Reducing Taxable Income with Forex 

Tax law determines the rules applied to forex trades, if you’re a non-U.S. citizen, you should check the capital gain taxation policy in the country of your residence. Odds are your taxes won’t break the bank, and if your forex trades take off — you can always explore obtaining a second passport.

For U.S. citizens just starting out, stick with the Section 988 classification initially as it is better suited for those experiencing net capital losses. Traders should decide between 988 and 1256 at the beginning of the year. It is not possible to retroactively change that status later to optimize the tax bill based on trading performance.

Here is a simple calculation that compares Section 988 versus Section 1256, for the same performance.

Section 988

  • Profit: $10,000
  • Loss: $7,000
  • Net Gain: $3,000
  • Income Tax (35%): 0.35 x $3,000

Total Tax: $1,050

Section 1256

  • Profit: $10,000
  • Loss $7,000
  • Net Gain: $3,000
  • Tax 1: 60% Net Gain at 15%: $3000 x 0.6 x 0.15 = $270
  • Tax 2: 40% Net Gain at 35%: $3000 x 0.4 x 0.35 = $420

Total Tax: $690 

How to Keep Track of Profit and Loss

Keeping an orderly log of profits and losses is the first step of making tax filing easier. For this purpose, consider the following steps.

1.     Calculate the net gain or loss by subtracting your starting balance from your ending balance.

2.     Add any withdrawals and subtract deposits to your account.

3.     Include rollover charges (interest paid) and subtract rollover income (interest income). This is the interest rate difference for holding the position overnight. It depends on the interest rate difference between the base currency and the quote currency.

4.     Attach other trading expenses, such as broker commission

Tips for Forex Taxation

Consider the following tips when planning for forex taxes.

  • Know what trading activity you engaged in: Explore your options at the beginning of the year. Consider all the possible trading activities and decide whether IRC 988 or 1256 is better for you.
  • Keep track of your trading account: Keep detailed records of your forex trading activities. It includes monthly profit-and-loss statements and any other trading-related expenses such as rollover fees and commissions.
  • Work with a tax professional: Consider consulting a tax professional, especially if you have other significant investments that could reduce your total tax bill. Working with a tax preparation service will significantly reduce the risk of underreporting as a forex trader.
  • Understand the foreign exchange market: Developing a clear understanding of how the forex market works can help retail forex traders stay on top of any taxation needs.

Stay on Top of Your Forex Trading Tax

Each individual’s tax situation will vary depending on where they live and the type of income they are making from trading. Generally speaking, if you make money from currency trading, it is likely to be subject to taxation. Tax treatment for spread betting, CFD, and income tax bracket may also vary.

However, the specific rules will depend on the country or region in which you live. In some cases, certain countries or regions may even offer special tax incentives to forex traders. It is important to ensure that you are aware of any applicable taxation laws in your area and to understand how they will affect your trading profits. Additionally, it is important to keep accurate records of your forex trading activities so that you can accurately report any related income or losses for tax purposes.

Keep Your Trading Activity Organized with These Top Forex Brokers

Successful forex trading starts with a good trading platform — a regulated intermediary that processes your trades. In the table below, you can find Benzinga’s recommended list of forex brokers.

  • Plus500 Forex
    Best For:
    Forex and CFD Trading for Mobile Users
    securely through Plus500 Forex's website
  • Forex.com
    Best For:
    Fast Execution and High-Volume Traders in the U.S
    securely through Forex.com's website

    CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 69% to 77.7% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work, and whether you can afford to take the high risk of losing your money.

    The products and services available to you at FOREX.com will depend on your location and on which of its regulated entities holds your account

  • IG Markets
    Best For:
    Fast Execution for U.S. Traders
    securely through IG Markets's website

    Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 71% of retail investor accounts lose money when trading spread bets and CFDs with this provider. You should consider whether you understand how spread bets and CFDs work, and whether you can afford to take the high risk of losing your money.

  • City Index
    Best For:
    International Forex and CFD Traders
    securely through City Index's website

    CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 69% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work, and whether you can afford to take the high risk of losing your money.

  • AvaTrade
    Best For:
    Non U.S. Forex & CFD Traders
    securely through AvaTrade's website

Frequently Asked Questions 

Q

Do you have to pay taxes on forex trading?

A

Yes, forex traders have to pay taxes. Forex futures and options traders pay taxes according to IRC Section 1256, while spot forex traders can choose between Section 1256 or Section 988 taxing treatment.

Q

Is forex taxed as capital gains?

A

It depends on the market. Futures and options traders use the 60/40 rule, where 60% of gains or losses fall in the long-term capital gain category, while 40% falls in the short-term and is taxed like ordinary income.

Q

How do you avoid taxes on forex?

A

American citizens who trade forex must pay their taxes even if using forex brokers outside the United States. While taxes are unavoidable, traders should consult with tax professionals to explore tax deductions related to forex trades. Such tax deductions may include capital loss related to CFD trading, which can be included in their tax return.

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About Stjepan Kalinic

Forex, Equity Analysis, and Financial Education