By Jason Van Steenwyk
Taxation is perhaps the least understood and least widely-reported aspects of forex trading. But it’s among the most important, because failure to understand the tax characteristics of the multiple different approaches to forex trading can cause you to leave thousands of dollars on the table in tax benefits. And it can even potentially get you in trouble with the law.
If you are getting serious about forex trading, one of the first things you should do is find an accountant, enrolled agent or other qualified tax professional who has specific expertise and experience working with other forex traders.
This is important because not every CPA is going to keep up with the latest rules and best practices affecting forex traders. Active forex traders, and those who trade forex options and futures, are a narrow and highly-specialized niche of clients, and many otherwise excellent practitioners
Why that is will become more and more clear to you as we get into more detail. Meanwhile, here is just enough info on the taxation of forex transactions to help you be dangerous. We will go into more detail into each of these topics in future articles here on Winners Edge Trading!
Three Types of Taxes
First, you should be familiar with the two basic types of taxes the IRS levies on individuals: Ordinary income tax, dividend income tax, and capital gains.
Ordinary Income. The IRS treats ordinary income as if it came from a wage-earner’s paycheck. The theory, right or wrong, is that the worker did not put any assets at risk to earn this money. Ordinary income is therefore taxed at the highest rate paid by individuals, which can vary by tax bracket. The higher the income, the more the tax on ordinary income eats out of a dollar earned.
Furthermore, unless you are getting a W-2 from an employer, ordinary income is generally subject to a 15.3 percent self-employment tax, which goes to fund Social Security and Medicare benefits. This is a major downside of ordinary income, from a tax point of view. However, the IRS is always on the lookout for taxpayers who attempt to evade self-employment tax by improperly classifying income as capital gains or dividend income. This is a common area of tax abuse and misunderstanding. It’s important to have a tax professional guide you through this if there is any doubt about the status of any kind of cash flow whatsoever.
Dividend income. Dividend income tax rates may be lower than ordinary income tax rates, if the income comes from a qualified source. The nature of forex investing means that you won’t be earning too much in the way of forex income via dividends, unless you happen to own a corporation that itself engages in trading forex and forex contracts.
Capital gains. Capital gains taxes are taxes on profits from a capital investment. These are different from income taxes in that the IRS assumes that the money you invest has already been taxed once – as income, generally – when you first received it. This is one of the reasons capital gains taxes on assets held longer than one year receive a very favorable tax treatment. They are taxed at much lower rates than ordinary income for every bracket. The catch: You have to hold the asset for at least a year to qualify for the lower, long-term capital gains rates. Otherwise, you will be liable for taxes at ordinary income rates.
The following information is taken largely verbatim from IRS Tax Topics 429 – Traders in Securities (Information for Form 1040 Filers).
The Three Types of Forex Trader
Are You a Trader, Investor or Dealer?
Caution: If you are running a professional, full-time trading practice, you may not qualify for favorable tax treatment of long-term capital gains. If your trading practice is the primary source of your income, for example, you fall under different tax rules than someone who makes a trade or two every month and mostly forgets about his activity for weeks or months at a time.
Investors. According to the IRS, “Investors” typically buy and sell securities and expect income from dividends, interest, or capital appreciation. In the case of forex traders, the usual source of profit is capital appreciation. They buy and sell these items and hold them for personal investment; they are not conducting a trade or business. Most investors are individuals. Sales of these securities result in capital gains and losses that must be reported on Form 1040, Schedule D (PDF), Capital Gains and Losses and on Form 8949 (PDF), Sales and Other Dispositions of Capital Assets, as appropriate. Investors are subject to the capital loss limitations described in section 1211(b), in addition to the section 1091 wash sales rules. Investors may be able to benefit from a deduction for the expenses of producing taxable investment income. These include expenses for investment counseling and advice, legal and accounting fees, and investment newsletters. These expenses are reported on Form 1040, Schedule A (PDF), Itemized Deductions, as miscellaneous deductions to the extent that they exceed 2% of adjusted gross income. Interest paid on money to buy or carry investment property that produces taxable income is also deductible on Schedule A, but under section 163(d), the deduction cannot exceed the net investment income. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss upon disposition of the securities. Review Topic 703, Basis of Assets for additional information. An investor is not subject to self-employment tax. For more information on investors, refer to Publication 550, Investment Income and Expenses.
Dealers. “Dealers” in securities may be individuals or business entities. Dealers purchase, hold, and sell securities to their customers in the ordinary course of their trade or business. Sometimes they maintain an inventory. Dealers are distinguished from investors and traders because they have customers and derive their income from marketing securities for sale to customers. Because they are in the trade or business of buying and selling, the gains and losses of dealers are classified per section 1236 as ordinary gains and losses. Section 1236 also requires that dealers must keep and maintain records that clearly identify securities held for personal gain versus those held for use in their business activity. Dealers must report gains and losses associated with dispositions of securities by using the mark-to-market rules discussed further below.
Traders. Special rules apply if you are a trader in securities, in the business of buying and selling securities for your own account. This is considered a business, even though you do not maintain an inventory and do not have customers. To be engaged in business as a trader in securities, you must meet all of the following conditions:
- You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation;
- Your activity must be substantial; and
- You must carry on the activity with continuity and regularity.
The following facts and circumstances should be considered in determining if your activity is a securities trading business:
- Typical holding periods for securities bought and sold;
- The frequency and dollar amount of your trades during the year;
- The extent to which you pursue the activity to produce income for a livelihood; and
- The amount of time you devote to the activity.
If the nature of your trading activities does not qualify as a business, you are considered an investor, and not a trader. It does not matter whether you call yourself a trader or a “day trader,” you are an investor. A taxpayer may be a trader in some securities and may hold other securities for investment. The special rules for traders do not apply to the securities held for investment. A trader must keep detailed records to distinguish the securities held for investment from the securities in the trading business. The securities held for investment must be identified as such in the trader’s records on the day he or she acquires them (for example, by holding them in a separate brokerage account).
Traders report their business expenses on Form 1040, Schedule C (PDF), Profit or Loss From Business. The Schedule A limitations on investment interest expense, which apply to investors, do not apply to interest paid or incurred in a trading business. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss upon disposition of the securities. See Topic 703, Basis of Assets. Gains and losses from selling securities from being a trader are not subject to self-employment tax.
The Mark-to-Market Election
Traders are entitled to an option not extended to investors: the usage of the mark-to-market rules. To explain, the tax treatment of sales of securities held in connection with a trading business depends on whether a trader has previously made an election under section 475(f) to use the mark-to-market method of accounting. If the mark-to-market election was not made, then the gains and losses from sales of securities are treated as capital gains and losses that must be reported on Form 1040, Schedule D (PDF). When reporting on Schedule D, both the limitations on capital losses and the wash sales rules continue to apply. However, if the mark-to-market election was timely made, then the gains and losses from sales of securities are treated as ordinary gains and losses (except for securities held for investment – see above) that must be reported on Part II of Form 4797 (PDF), Sales of Business Property. Further, neither the limitations on capital losses nor the wash sale rules apply to traders using the mark-to-market method of accounting.
In general, the mark-to-market election must be made by the due date (not including extensions) of the tax return for the year prior to the year for which the election becomes effective. The election is made by attaching a statement either to your income tax return or to a request for an extension of time to file your return. The statement should include the following information:
- That you are making an election under section 475(f);
- The first tax year for which the election is effective; and
- The trade or business for which you are making the election.
Refer to the Form 1040, Schedule D Instructions (PDF), Capital Gains and Losses, for further information on how to make the mark to market election.
After making the election to change to the mark-to-market method of accounting, you must change your method of accounting for securities under Revenue Procedure 2011-14. In addition to making the election, you will also be required to file a Form 3115 (PDF), Application for Change in Accounting Method. The procedures for making an election are described in Publication 550 under the section called “Special Rules for Traders in Securities,” on our website.
If you have made a valid election under section 475(f), the only way to stop using mark-to-market accounting for securities is to request and receive written permission from the Service to revoke the election. Non-filing of the Form 3115 mentioned above will not invalidate a timely and valid election. To request permission to revoke your election under section 475(f), you must file a second Form 3115 and pay a fee.
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