Tax Tips for Forex Traders (Part 2)

02/20/2008 12:00 am EST

Focus: FOREX

Robert Green, CPA


Spot and forwards may or may not have different tax treatment. Some tax professionals treat forward contracts as part of IRC 1256 by default, whereas other professionals think a forward forex trader can choose between IRC 1256 (60/40 treatment) and IRC 988 (ordinary gain or loss).

If forwards are IRC 1256 by default, a trader can still navigate into IRC 988 by filing a contemporaneous internal election to opt out of IRC 1256 for IRC 988.

Some tax professionals treat spot contracts as part of IRC 988 by default, whereas other tax professionals think that spot contracts in major currencies (with RFCs) may also be treated like forwards above.

IRC 988 appears to state that if a trader does not "take or make delivery" of the actual currency–and most traders don't make or take delivery–then the spot contract can be treated like a forward contract.

The key issue for forward contracts to be included in IRC 1256 is that the forward contracts must be in major currencies (not minor currencies), for which RFCs (regulated futures contracts) also are traded. For example, forward contracts in the Euro qualify since there are Euro currency futures traded on futures exchanges.

How to proceed with tax filings? We believe that a "reasonable cause" position (which is weaker than a "more likely than not" position) can currently support treating spot like forwards, providing the spot is in a major currency for which RFC futures contracts are also traded.

So, if you want to claim IRC 1256 60/40 lower tax rates on spot trading gains, it's wise to get a "reasonable cause" legal opinion. Although the IRS requires tax preparers to have "more likely than not" positions to avoid preparer penalties, they have waived this higher standard for 2007 tax returns, allowing "reasonable cause" positions.

Our firm works closely with a tax attorney who can provide these legal opinions for our tax preparation clients.

But also consider that "reasonable cause" positions go both ways. That means that deducting a spot forex loss as ordinary (IRC 988) may also require a "reasonable cause" position. Yes, this seems like circular calculation reasoning.

To play it safe, if you want IRC 988 ordinary gain or loss treatment on spot and/or forward forex, we suggest you consider opting out of 1256 for IRC 988 by filing an internal contemporaneous election.

In all cases, if you trade forex, anything other than currency futures on US exchanges, it's wise to consult with a forex tax expert (such as our firm). We are available for consultations and our firm prepares tax returns for hundreds of forex traders.

Our tax attorneys and CPAs are working hard to flush out more answers on this subject, so stay tuned for content updates. The problem is that IRC 988 and IRC 1256 are conflicting sections. IRC 1256 (60/40 capital gains treatment) and IRC 988 (ordinary gain and loss treatment) have always been conflicting codes and regulations, especially when it comes to currency traders.

After all, each code section was written for different types of taxpayers (manufacturers versus traders/dealers), by different IRS groups, in different decades.

In 1982, Congress recognized that forex traders acted like futures traders so they fixed IRC 1256 by adding "foreign currency contracts" to the IRC 1256 definitions. Congress wanted to accommodate currency traders, putting forex (OTC interbank off-exchange markets) on par with currencies traded as "regulated futures contracts" (RFCs), which are (the original) 1256 contracts. This started the conflict between IRC 988 and 1256. IRC 988 already included "foreign currency transactions" and "forward contracts" in the interbank market, which Congress said it now intended to be included in IRC 1256.

Congress was clear about including "forward contracts" in forex in IRC 1256, but they did not mention spot forex, too. Foreign currency contracts under 1256 must be in a foreign currency for which there is regulated futures trading (these are major currencies, all others being minor).

The IRS was supposed to work this all out but they never did in a clear way, or even at all. So there is room for much interpretation.

Spot forex is the odd man out. A brewing trouble spot for Congress and the IRS is "spot" forex (no pun intended). Congress and the IRS have not specifically named "spot forex" per se as being eligible in IRC 1256 "foreign currency contracts" and spot is clearly named as eligible in IRC 988.

But spot forex is just like forward forex, and if you apply the same logic for how Congress justified putting forward forex into IRC 1256, the same case can be made to include spot forex as well.

Traders don't make or take delivery in non-functional currencies for the spot forex contracts they trade. Rather, they trade the contracts before settlement in the same way they trade forward forex. The only difference is that spot settles in less than 48 hours and forward settles in more than 48 hours.

What opened the door to IRC 1256 for forward forex was that there were currency futures contracts in the same currencies for the forward forex contracts, and the same case applies to spot forex. Keep in mind that there has been a bevy of new currency futures created since the IRC 988 and 1256 rules were modified by Congress.

We currently think there is some room for interpretation on spot forex (see above), which hasn't yet been barred from IRC 1256 as OTC currency options were recently in Notice 2007-71.

More tomorrow in Part 3. Part 1 |  Part 3  |  Part 4

By Robert Green of

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