Forex Favorable Tax Treatment

Cash Forex is subject to IRC section 988 (treatment of certain foreign currency transaction). The principal intention of IRC section 988 is to tax foreign currency transactions that take place in day-to-day international business operations, such as manufacturing and exporting. Fluctuations in exchange rates should be treated as ordinary income or loss and reported as interest income or interest expense.

In the Forex interbank market investors are exposed to foreign exchange rate fluctuation and view their currency holdings as "capital assets". On this premise, currency investors may elect out of the ordinary gain or loss treatment in IRC section 988, thereby falling back to the default section 1256 contract treatment, or 60/40 capital gains and losses (i.e., 60% is taxed at long-term capital gains rates and 40% are taxed at short-term capital gains rates).

When electing out of IRC section 988 the rules require the investor to elect out on a "contemporaneous basis". This means hindsight is not allowed and you must make your decision in advance of the trades. The election out of IRC section 988 should be filed "internally", which means the investor will keep their election decision in their own records as opposed to filing it with the IRS.

With the top Federal Income Tax Bracket of 35% on regular income and 15% on capital gains, the current maximum blended rate of 60/40 tax treatment is 23%.

Currency futures traded on a regulated exchange are treated the same as other commodities and futures, that is they fall under IRC section 1256 contracts. Capital gains and losses are reported on form 6781 (Gains and Losses from Section 1256 contracts and Straddles). This allows business traders and investors to split the gains and losses 60/40 on Schedule D (60% is taxed at long-term capital gains rates and 40% are taxed at short-term capital gains rates).

With the top Federal Income Tax Bracket of 35% on regular income and 15% on capital gains the current maximum blended rate of 60/40 for currency futures is 23%.