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Income Tax Treatment of Forex Trading Gains and Losses

Income Tax Treatment of Forex Trading Gains and Losses

Have you found success with your currency trading strategies? If you have, congratulations! That’s the goal of any serious forex investor: to develop a system which helps them to accurately predict forex exchange rates and make a tidy profit. Not everyone gets to that point, so you should consider yourself to be an elite forex trader if you are able to make a regular profit from your trades.

However, your success also brings a new set of challenges in the form of money management. Not only do you need to worry about how to save (or spend) your money, but you need to worry about the tax implications of your forex investments. To make things easier, we’ve put together the answers to some frequently asked questions about the tax ramifications of forex investing.

If you make money in the forex markets, do you have to pay U.S. income tax on that money? Does the IRS know that you made money in the forex markets? What about if you lose money trading currencies? Can you write that off on your taxes?

As the online forex market continues to grow, more and more individuals will encounter these thorny issues of how to treat forex trading gains and losses as far as reporting your income tax goes.

Consultation with a knowledgeable accountant is always recommended if you are seeking personalized advice, but let’s see if we can’t address a few important forex trading income tax questions with the following forex tips for tax purposes:

Do I Have to Pay Federal and State Income Tax on Forex Trading Gains?
If you live in the United States, you are supposed to pay income tax on all your income for the year. This would include forex trading gains.

Can I Write Off My Currency Trading Losses?

This question is best answered by asking another question: If you have gains from trading forex next year, are you going to report and pay income taxes on those gains?

If so, you may be able to write off your currency trading losses as a legitimate business loss, provided you meet the other requirements as set out by the IRS, chief among them that your motivation for engaging in forex trading is to create a profitable business.

So far, IRS has not, as a general rule, denied serious, dedicated forex traders from claiming losses related to running a forex trading operation.

What Form Do I Use to Report My Forex Gains and Losses?

This is where that knowledgeable accountant comes into the picture. But if you want to take a gander for yourself, look up IRS Form 6781.

This is the form that is used for reporting income related to contracts or “straddles,” which category includes several forms of currency trading.

If you trade the spot forex market, which nearly all forex traders do, it may be advisable to make an election with the IRS with regard to Section 988 of the IRS code.

Making an election according to Section 988 can protect your ability to use spot forex losses as tax deductions.

Does the IRS Know If I Make Money Trading Forex?

Not as easily as they know if you worked at X Company or sold stock on the New York Stock Exchange. But still, don’t underestimate the fact that what the IRS does not know now, they could very easily find out in the future, if they really wanted to know.

There is no official reporting requirement for the “payer,” in this case your forex broker, but you could still be audited on the basis of unreported income. The IRS (or the state taxing authority) would have to take the extra step to look at how much money you’re spending, and then compare that to your reported income, but that can be done.

Starting in 2009, the IRS has stated that there will be more usage of “paid to” information as a means of finding tax cheats. For example, when someone is paying a mortgage to a bank, the bank reports that interest to the IRS. If the IRS does not see income reported from the taxpayer who’s paying that mortgage, an income audit may be initiated.

But no, technically, the IRS does not know if you make money trading forex.

Does Income from Currency Trading Qualify for the Lower Capital Gains Rate?

The income tax rate on capital gains is typically lower than the income tax rate on ordinary income, such as wages or bank interest. But do forex trading profits qualify as capital gains?

Generally speaking, 60 percent of forex trading profits would qualify for long-term capital gains tax treatment (translation: 15 percent tax).

The other 40 percent of your profits would be subject to your marginal tax rate (translation: 35 percent federal is the max).

The best rule of thumb with regard to forex trading income tax law is to treat your gains and your losses with consistency: if you’re going to take deductions, make sure you report income; don’t just report your losing years to save money on taxes.

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