Tax Tips for Forex Traders (Part 4)

02/22/2008 12:00 am EST

Focus: FOREX

Robert Green, CPA

CEO, GreenTraderTax.com

"Assuming that the first test is met, the second requirement is that the contract must be traded in the interbank market. The legislative history describes the interbank market as an informal market through which certain foreign currency contracts are negotiated among any one of a number of commercial banks. Contracts traded in the interbank market generally include contracts between a commercial bank and another person as well as contracts entered into with a futures commission merchant (FCM) who is a participant in the interbank market. According to the legislative history, a contract that does not have such a bank or FCM, or some other similar participant in the interbank market, is not a foreign currency contract."

Will forex brokers ever be required to report forex on 1099s?

A retail forex broker recently consulted with us about whether or not 1099s should be issued for their forex trading accounts. Industry practice and forex tax law dictates that forex accounts are exempt from 1099 reporting. Only interest income on forex accounts is 1099 reportable.

The above forex broker told us that their big-four accounting firm initially wanted them to issue 1099s for forex accounts in the same way a futures broker issues 1099s for IRC 1256 contracts. The big four firm explained that forex was now considered a futures related product. We later learned that the big four firm changed their mind and decided to continue the industry policy of no Form 1099 reporting for forex trading gains and losses.

Each year, our tax preparers notice that two forex brokers (not naming names here) issue futures type 1099s for their forex trading accounts. We recently heard that one of these forex brokers only sends the 1099 to their clients and not also to the IRS. That's odd, as 1099s are intended to be filed with the IRS.

Tax reporting for forex.
What should you do if you have forex trading losses reported on a 1099 for IRC 1256 contracts?

If your position is that your forex loss should be ordinary (see above), consider filing the forex trading loss first on Form 6781 (so the IRS can match the 1099 reporting with their computers), and then transfer the forex trading loss to another area of the tax return (line 21 of Form 1040 for investors or Form 4797 Part II for business traders).

Using line 21 Other Income or Loss on Form 1040 for IRC 988 transactions is industry-accepted practice, although it's not stated in any IRS tax forms or form instructions.

Note that IRC 988 writes about interest income and expense for reporting IRC 988 transactions. Consider that forex traders do not borrow money per se and they don't pay interest to lenders, so using interest expense makes little sense.

If traders had to report forex trading losses as interest expense, it would be a problem for many investors, but not business traders. That's because investors may only deduct investment interest expense up to their investment income, with the rest carried over to subsequent years. Conversely, in all cases, business traders are allowed full business interest deductions, whether they have income or not.

Business traders (with trader tax status) should consider using Form 4797 (Sale of Business Property Part II ordinary gain or loss) rather than line 21 of Form 1040. Securities traders who elect and use IRC 475 mark-to-market accounting also use Form 4797 Part II; which is automatically picked up in NOL (net operating loss) calculations. Line 21 is more of a red flag to the IRS.

Traders need to file a Form 8886 (Reportable Transaction Disclosure Statement) if they have "transactions that result in losses of at least $2 million in any single tax year ($50,000 if from certain foreign currency transactions) or $4 million in any combination of tax years..." Other transactions mentioned on Form 8886 mostly relate to tax shelter transactions.

Forex traders should consult a forex tax expert (such as our firm) for further discussion and decisions to make for tax reporting of their forex transactions. We also recommend that forex traders include a tax return footnote with their filing to explain this treatment.

Warning label and suggestions for how to proceed.
Traders should consult a forex tax expert on a one-by-one consultation basis. Our Web site content above and throughout is for educational purposes only. We are not responsible for any positions you extrapolate and take on your own.

GreenTraderTax does provide consultation and tax preparation services. Our independent tax attorneys provide legal opinions when needed (see above).

At tax time, it's important to provide your accountant with your forex trade accounting, by spot, forwards, OTC currency options, futures or otherwise.
We have not seen the IRS disallow forex tax treatment based on our prior content. But it's too uncertain to tell how the IRS may react in the future.

It's possible that one IRS agent or office can seek to deny ordinary loss treatment for forex trading losses where another IRS agent or office can seek to deny lower 60/40 tax rates on forex trading gains. Although, that appears to be mutually exclusive, it's entirely possible in the real world!

If you get an IRS notice or action in that regard, we strongly suggest that you contact our firm for help.

If you have any questions or need help on forex tax, please e-mail us at info@greencompany.com or call us at 877-662-2014.

Part 1 |  Part 2  |  Part 3

By Robert Green of GreenTraderTax.com

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