How Do Forex Taxes Work?

The post How Do Forex Taxes Work? by Stjepan Kalinic appeared first on Benzinga. Visit Benzinga to get more great content like this.

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.

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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.

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%.

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 tax rate for capital gains, such as Greece at 15% or Switzerland 0%.

Furthermore, there are special considerations. For example, the U.K. has a 20% capital 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 

If you’re a non-U.S. citizen, you should check the capital tax gain policy in the country of your residence. Odds are your taxes won’t break the bank, and if your trading takes 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 Tracks 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.

• 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 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.
• Consider consulting a tax professional, especially if you have other significant investments that could reduce your total tax bill.

Top Forex Brokers for Keeping Taxes Organized

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

Frequently Asked Questions 

The post How Do Forex Taxes Work? by Stjepan Kalinic appeared first on Benzinga. Visit Benzinga to get more great content like this.