How Is Forex Taxed
Taxes may be the only certain thing in this world (next to death, of course), but it’s fair to say they aren’t the simplest nor the most enjoyed thing. Well, forex taxes aren’t an exception.
Indeed, as a forex trader, you must consider the tax implications of your trades. Knowing which taxes on forex trading to file and how to do it is vital to ensure you maximize your returns and avoid legal issues.
And that is precisely what we will tackle today.
By the end of this guide, you’ll have learned how forex taxes work, how to file them, and how to soften their impact on your returns.
DISCLAIMER: The information provided in this guide is based on our own research and experience. For any tax advice or information, please consult with a professional tax advisor in your respective jurisdiction.
How Do Forex Taxes Work in the US?
Forex taxes usually fall under income tax or capital gains rules. In short, income taxes on forex trading refer to the tax paid on overall earnings. Capital gains tax, on the other hand, refers to the tax paid on profits from selling assets.
Traders must also adhere to strict tax reporting requirements. These vary depending on how you trade forex. Namely, whether you trade futures and forex options or if you’re an over-the-counter trader.
Tax Considerations on Forex Options and Futures
First, we have forex options and futures contracts. These two instruments fall under the Internal Revenue Code (IRC) Section 1256, meaning they are subject to the 60/40 tax consideration.
Essentially, it implies that 60% of forex gains and losses are counted as long-term capital gains or losses, whereas the remaining 40% are counted as short-term.
What about the tax rate? For short-term gains, the maximum taxation rate is 37%, whereas the long-term tax rate is fixed at 20%. This means that these derivatives lower the average tax rate, favoring high-income traders (generally those in the 22% tax rate bracket or higher).
Tax Implications for Over-the-Counter Investors
Spot and over-the-counter (OTC) traders are taxed according to the IRC Section 988 instead of 1256. These are tax implications for foreign exchange transactions settled within two days, which are treated as ordinary gains and losses.
These tax requirements aren’t as beneficial for high-income traders. On the other hand, they are less complex and can prove themselves substantially advantageous if you experience a net loss.
That’s because, while ‘1256 traders’ are subject to a $3,000 capital loss limitation, ‘988 traders’ can use all their losses to reduce the income tax rate.
How to File Forex Taxes?
Okay, now it’s time for the tricky part – deciding under which taxation rules you’d like to file forex taxes. Individual forex traders must decide whether to trade under the IRC 1256 or IRC 988 by the first day of each calendar year.
As covered, IRC 988 rules are simpler, offering a constant tax rate for gains and losses. Furthermore, there’s no $3,000 capital loss limitation limit. This makes IRC 988 more beginner-friendly, favoring forex traders who may experience significant losses during their first year of trading.
On the other hand, you have an option to be taxed under IRC 1256. The tax rules there are more complicated, but they offer approximately a 12% lower tax rate for traders with net gains.
Which option is better? That depends on numerous factors, such as your income tax brackets, average gains and losses ratio, and instruments traded. Usually, spot traders fall under the IRC 988 category, whereas futures and options traders take advantage of IRC 1256 tax rules.
How Much Do Forex Traders Pay in Taxes?
When filing forex taxes, their amount will depend on the income tax rate you fall under. In the United States, the income tax rate starts at 10% and goes up to 37%. The rule is simple: the more income you earn, the higher your taxation rate.
As you’ve already learned, how much you’ll pay for your forex trades will also depend on whether you opt for IRC 1256 or IRC 988. In the first case, 40% of your forex income will be taxed according to your federal tax rate bracket, whereas the remaining 60% will be taxed under the fixed rate of 20%.
How to Reduce Forex Taxable Income?
The simple way for US citizens to reduce their taxable income is to use net trading losses. In the case of IRC 988, there’s no limit on the deductible losses, whereas IRC 1251 regulations come with a $3,000 annual cap on trading losses.
Forex Tax Rates in Different Countries
In this guide, we mostly cover the US side of things. For those living outside the United States, the forex taxation situation is, of course, entirely different.
For instance, in some countries, forex trading is tax-free, including the United Arab Emirates, Georgia, Monaco, Turkey, and the Bahamas. Most countries, however, have their own forex taxation rules one must consider before trading abroad.
UK Forex Tax Laws
The UK is an interesting example here. For instance, when treating forex trading as a side gig in the UK, you can benefit from the Trading Allowance, which offers tax-free forex trading as long as the annual profit doesn’t exceed £1,000. Anything above will be taxed under the standard UK tax rates.
UK forex taxes also vary depending on your trading instrument. For example, spread betting in the UK is tax-free as it doesn’t require you to own the underlying asset to trade it. Furthermore, the UK’s HM Revenue & Customs doesn’t even consider spread betting as trading, treating it as gambling.
On the other hand, when trading CFDs, you’ll need to follow the same tax rules as those trading commodities or bitcoin. This means you’ll need to pay both capital gains tax and Stamp Duty Reserve tax on any of your earnings.
How to Keep Record of Forex Taxes?
Filing your taxes can be a complex and often frustrating process. However, there are several rules to follow that will make this entire process much easier. The best place to start is to keep a detailed record of your capital gains and losses. Here’s how to keep it:
- Subtract your starting balance from the end balance to calculate your net gain or loss.
- Add withdrawals from and subtract deposits to your trading account.
- Add your paid interest and subtract interest income – these are the rollover charges for holding positions overnight.
- Add other expenses, for example, a brokerage commission.
Stay on Top of Your Forex Taxes
Forex taxes can seem intimidating, especially if you’re only starting your forex trading journey. Understanding the basics of how forex is taxed, however, should be enough to make your life at least a little easier.
Remember that everything starts with choosing the appropriate tax code. In the US, you can choose between IRC 1256 and IRC 988, each coming with distinct potential benefits and disadvantages.
This is the decision you’ll need to make no later than the first day of each calendar year. And once you make it, you won’t be able to change it later. That is why it’s vital to keep detailed track of your transactions, which will help you make a tax decision that best suits your circumstances.
However, the best decision you can make to ensure your forex taxes are filled correctly is working with a professional tax accountant. This will significantly reduce the risk of underreporting. Plus, savvy professionals can help you find ways to reduce your forex taxable income.
Final Thoughts
And that would be it.
As you can see, forex taxes aren’t as horrendous as many paint them. Sure, in a perfect world, we would be able to keep all our trading profits, but taxes, as Benjamin Franklin famously said, are inevitable.
And remember, whenever you need capital for your forex trading efforts, City Traders Imperium can help. Sign up for one of our funding programs today or show your skills in our Challenge.
