Forex trading is the practice of exchanging foreign currency to generate a profit. Forex gains are either subject to long-term capital gains tax or are taxed as ordinary income, depending on the types of contracts you trade.
If you want to make money as an investor, there is no shortage of options to choose from. While many people opt for stock trading, others choose to make their money through foreign exchange transactions, also known as forex trading. As a forex trader, you can take advantage of fluctuations in world currencies to earn a profit.
As you would with other types of investing, you’ll have to pay taxes on the money you make through forex trading. The amount you’ll pay and the type of taxation you’ll be subject to will depend on the type of trading you engage in.
In this article, we’ll go over what forex trading is, the rules of forex taxation, and how to reduce the amount you’ll pay in taxes as a forex trader.
What is forex trading?
Forex trading — short for “foreign exchange trading” — is the process of exchanging one currency for another.
If you’ve ever traveled to a foreign country, you probably exchanged currency at the airport so you could use cash in that country during your trip. And if you travel to the same country frequently, you may have noticed that you don’t always get an equal amount of foreign currency in exchange for the same number of dollars.
The same principle applies to forex trading, except that forex traders exchange currency on the foreign exchange market as a way to make money. According to Ahmed Sufyan Samee, CEO of the foreign exchange company MTFX, “It is a way for investors to make profits by taking advantage of fluctuations in currency values. The goal of forex traders is to buy low and sell high, although there are other strategies available as well.”
Basically, different currencies fluctuate in value relative to one another, and the goal of forex trading is to profit from those fluctuations. For example, you might exchange your U.S. dollars for euros because you believe the euro is going to rise in value compared to the dollar. If it does, you can then exchange the euros back into a higher amount of U.S. dollars to turn a profit.
Forex trading is a relatively high-risk trading strategy. You probably wouldn’t want to build most of your portfolio with forex, but if you have a bit of extra disposable income to invest, you might decide to make it a small percentage of your portfolio.
That said, to make sure forex trading is right for you, you may want to speak with an investment advisor before you get in too deep.
What is the monthly income of a forex trader?
The amount you’ll make as a forex trader varies drastically depending on the volume, the size, and the success of your trades. Keep in mind that forex trading is a high-risk investment strategy, so your losses may be high compared to your gains.
How do forex trading taxes work?
As with other forms of investing, you must pay taxes on the money you earn from forex trading. The tax treatment of this investment strategy can be a bit complex, as it depends partially on the type of forex trading you practice.
Forex options and futures
Options and futures — both known as derivatives — are contracts that lay out the terms of a future transaction. In both cases, an investor is essentially betting on which direction the price of an asset will move. Some derivatives are profitable if the price moves down, while others are profitable if the price moves up.
Forex options and futures fall within Section 1256 of the Internal Revenue Code. Gains on these trades are subject to a 60/40 tax consideration, which is structured as follows:
- 60% of Section 1256 gains are subject to the long-term capital gains tax.
- 40% of Section 1256 gains are subject to the short-term capital gains tax.
The same 60/40 consideration also applies to forex trading losses, which we’ll discuss further on.
Over-the-counter (OTC) and spot forex trading falls under Section 988 of the Internal Revenue Code — and therefore has a different tax treatment.
Section 988 gains and losses are treated as ordinary income and losses, meaning they are also taxed as such. Unfortunately, this means that gains aren’t eligible for the more beneficial long-term capital gains tax rates. The difference will be especially noticeable to investors in high-income tax brackets, who will pay a 37% tax rate on OTC and spot forex gains.
That being said, there is a benefit to your investments being taxed as Section 988 transactions: If you experience a net loss for the year, you can count the full amount as ordinary losses. This differs from the treatment of Section 1256 losses, in which only the first $3,000 can be counted as a loss.
How to choose a type of forex trading
A unique characteristic of forex trading is that you must decide by the first day of the year whether you’re going to trade under Section 1256 or Section 988. Choose wisely, because once you’ve settled on one, you can’t change your mind later.
Section 1256 contracts have a more favorable tax treatment for investors who have a gain at the end of the year. However, forex trading is a high-risk investment strategy, so your chances of ending the year on top may be lower than with other investments.
Because of this, many beginner forex traders opt for Section 988 contracts. Not only are they simpler, but they also have a more favorable tax treatment for net losses, which aren’t uncommon — especially when you’re just getting started.
Given the complex nature of forex taxation, the wisest move would likely be to work with an accountant or tax preparation software or expert. Because everyone’s financial circumstances are different, it’s ultimately up to you (and your accountant) to decide which forex trading strategy is the better option for you. If you’re not sure where to start looking for tax help, take a look at the list of software and prep experts below.
How to track your forex trading tax
The brokerage firm you use for forex trading may provide you statements each month, as well as tax forms at the end of the year. However, it’s also wise to maintain your own records and calculations throughout the year. To do that, take the following steps:
- Subtract your starting forex balance from your ending balance to determine your net gain or loss.
- Add withdrawals you made to your account and subtract any deposits.
- Add any interest you paid and subtract any interest you earned.
- Add your other trading expenses, including broker commissions.
As long as you provide accurate paperwork to your accountant, they should be able to calculate your forex taxes for you. Keep in mind, however, that their math will only be as good as the information you provide, so be sure to stay on top of your records.
How to reduce your forex trading taxes
A successful year of forex trading — that is, a year that ends with a large net gain — is a huge triumph. However, it can also increase your tax burden significantly. In your first year of forex trading, a large tax bill can easily take you by surprise, but the good news is that it’s possible to reduce the taxes on your investments.
Deducting your forex losses
The simplest way to reduce your forex trading taxes — and, in fact, the best way to reduce any investment taxes — is to offset them with losses.
For example, imagine you made a profit of $10,000 from forex trading by the end of the year. However, you also had $5,000 worth of losses from your less successful trades. Instead of paying taxes on the full $10,000 of profit, you can deduct your $5,000 loss and only pay taxes on the $5,000 net gain.
According to Samee, many forex traders also intentionally trade for a loss to reduce the amount of taxes they’ll owe, a common investing practice known as tax-loss harvesting: “One of the most effective methods is to take advantage of loss harvesting, which involves trading in a way that generates losses that can be used to offset any gains made through forex trading.”
Finally, forex traders may be eligible to deduct some of the expenses related to their investments. The more expenses you have, the more you can offset from your forex gains. According to Samee, “Additionally, investors can also benefit from claiming related expenses as deductions from their taxes. These expenses may include costs associated with research and analysis, software subscriptions, and other business costs.”
Examples of expenses that may be eligible for deduction include a home office, office supplies, education expenses, and professional services.
- Forex trading, or foreign exchange currency trading, is the process of exchanging one currency for another with the goal of taking advantage of price fluctuations to earn a profit.
- Different types of forex contracts are subject to different tax rules. Section 1256 trades are subject to both short-term and long-term capital gains taxes, while Section 988 trades are always subject to regular income tax.
- You can reduce your forex trading tax by offsetting your gains with your losses, a practice known as tax-loss harvesting.
- Because it can be difficult to figure out how much tax you’ll owe on your forex transactions at the end of the year, it’s a good idea to consult with an accountant who is knowledgeable about forex tax treatment.
Start investing with the right firm
Are you interested in forex? Before you begin trading, it’s important to choose the right brokerage firm.
You’ll obviously want an account with a firm that can accommodate forex trades, but if you’re also considering trading stocks and other assets, you’ll want a brokerage that offers those as well. Check out our roundup of the best online brokerage accounts to find the right firm for your needs.
View Article Sources
- 26 U.S. Code § 1256 – Section 1256 contracts marked to market – Cornell Law School
- Topic No. 409 Capital Gains and Losses – IRS.gov
- Form 6781: Gains and Losses From Section 1256 Contracts and Straddles – IRS.gov
- 26 U.S. Code § 988 – Treatment of certain foreign currency transactions – Cornell Law School
- Investment Guide for Beginners – SuperMoney
- How Capital Gains and Losses Affect Your Taxes – SuperMoney
- Accountants vs. CPAs: Which Is The Right Choice For You? – SuperMoney
- How to Avoid Capital Gains Tax on Stocks – SuperMoney
- Tax Deductions and Credits List: Complete Guide for 2023 – SuperMoney