The biggest market in the world for trading is known as the foreign exchange market or Forex market with over $4 trillion changing hands every single day. This market is 12 times greater than the average daily turnover on the global equity market and more than 50 times greater than the average daily turnover on the NYSE.
It is more than around thousand years to be trading in the foreign currencies. Some well- known traders were the Middle Eastern moneychangers which helped to exchange coins to facilitate trade.
A Little Background…
The Tax Reform Act 1986 implemented covers the provisions of transactions which comes under Section 988. The ordinary gains or losses of Forex transactions are the default method of transaction for currency traders. The Forex gains are being taxed as ordinary income in whatever tax bracket one fall under. For example:
Joe Trader is married and makes $1,00,000 salary per year and has a good year trading Forex making $50,000 for the year. Joe falls in the 25% tax bracket making his tax due on his Forex gain $12,500 ($50,000*25%).
But What About the Forex Losses…?
The losses incurred under the Forex are treated as ordinary losses which are further allowed to offset from any income from your tax return. Let’s take the example of Joe again:
Instead of making profit of $50,000, Joe made the loss of $50,000 in Forex trading. The loss of $50,000 can be taken against his W-2 income, making his taxable income $50,000. If the Forex loss would have been treated as capital loss instead of ordinary loss, then Joe would have only be able to take $3,000 off from his taxes, and making his taxable income amounting to $97,000. The remaining loss amounting to $47,000 would have to be carried forward and to be used up in the future years.
So what type of Forex trader benefits one gets from Section 988 tax treatment? According to me, if a trader is not making profits on a regular basis and he has some other earned income on his tax return, then he should stay under Section 988 taxation in order to fully utilize the losses which comes from Forex trading. In case if a trader is not making profits on a regular and he neither have any other earned income then he should consider what a profitable Forex should opt for i.e., to opt out Section 988 tax treatment.
IRC section 988(a)(1)(B) provides Forex traders with a way to opt out for the ordinary gain/loss tax treatment.
Except as provided in the regulations, a taxpayer may treat any foreign currency gain or loss as as capital gain or loss before the closure of the day on which the transaction has taken place.
This exception helps the Forex traders with the option to opt out of ordinary gain/loss treatment making the Forex trades taxed under same as section 1256 contracts. Section 1256 contracts are more beneficial as these are taxed at the rate of 60/40. 60% are taxed at long term capital gain rates whereas 40% are taxed at short term capital gain rates. The minimum tax rate on ordinary income is 39.6% whereas the maximum tax rate on Section 1256 contracts in comparison is 28%, almost the reduction of 30% in taxation on the gains.
Using the above given example, if Joe had opted of the section 988 tax treatment, then his tax rate on $50,000 Forex gain at 60/40 would drop to 24%, saving him $3,000 in taxes that year.
The Bottom Line
In order to save taxes, the Forex profitable traders should not opt out of Section 988 tax treatment. However, this thing makes sense for the ones who are not consistently making profits and neither have any earned income on their tax returns. The ordinary loss gets ended up waste as it cannot be carried forward to future tax years in the case where the trader has an ordinary loss and has no earned income to offset it. If one opts out and elects Section 1256 tax treatment, then the loss can be carried forward and can be used against the future capital gains.
If still any confusion prevails regarding whether to opt out or not, then one should always seek the advice of a knowledgeable trader tax specialists in order to take a right decision.