The Taxation of Foreign Exchange Markets Trades

Ali Qamar

Updated: 16 November 2023

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How Forex Trades are Taxed

It is estimated that around 4 trillion US dollars of foreign exchange are traded every day, making the foreign exchange market one of the largest markets in the world.

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The Forex market is such a significant market in the world that should not be underestimated at any cost. In less than a year, the foreign exchange market trades currency that is worth the global GDP by around 25 times.

However, tax tariffs associated with the Foreign Exchange Market around the world do not get the much-needed coverage and consideration that it much requires. This is unfortunate as the lack of this vital information limits further investments in the exciting market.

Since time immemorial, people have been engaging in FOREX trading as a safe way of getting profits from investments. The global network of government central banks, international financial institutions, brokerage firms, hedge funds, commercial, and investment banks avail investors the opportunity to capitalize on the rise and fall of currency.

However, the foreign exchange market is an extremely volatile market that can serve an investor either profits and losses in a blink of an eye.

Consistently, the values of world currencies keep on changing serving traders and investors an opportunity to speculate and profit from exchanging foreign currencies through their FOREX accounts.

Keeping in mind that there are different types of foreign exchange trades, investors and traders have different ways of claiming losses and gains on their taxes. What this means is every kind of foreign exchange trade can offer rewards or disadvantages to investors depending on whether the foreign exchange (FOREX) account makes a profit or not.

When it comes to filing income tax returns, currency traders usually receive special treatment from tax bodies considering the unique nature of the forex business.

It is the mandate of investors to consider how they will file for their taxes before engaging in their first trade.

On this article we will look at the tax landscape for foreign exchange traders, and why it is recommended to have a Traders Accounting tax professional to guide you through the ups and downs of the forex market.

Forex Trading

Foreign exchange is traded in two ways: as futures or currency futures and as cash forex.

Currency Futures

A currency futures contract is done on regulated commodities exchanges and is a legally binding contract that compels the involved parties to exchange a specific amount of currency pair at a pre-agreed exchange rate in a pre-agreed future date.

In an event where the seller does not close out the position ahead of time, they can either own the currency at the future agreed date or may risk that the currency will be cheaper in the spot market before the settlement date.

Currency futures are usually utilized by global companies that seek protection against foreign exchange rate movements.

Spot Forex

On the other hand, spot fx involves underline currencies being physically traded following the settlement date. As it usually takes 2-days to transfer funds between bank accounts, delivery in spot fx usually takes 2-days after execution.

Spot fx is most common in the commodities market involving the actual exchange of the underlining currencies. For instance, when someone goes to a forex bureau to exchange currencies, they are participating in the Forex Spot market. The Spot FX market takes the largest share of foreign exchange, realizing about 1 trillion US dollars per day in transactions.

It is essential to know which tax category and accounting rules your trade fall to file the correct tax returns to enable you to receive optimal tax advantage. Cash Futures and Spot Fx are subjected to different tax categories.

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Tax Categories

Section 1256

Under section 1256, forex investors report capital gains on the IRS gains and losses Form 6781 to receive significant tax advantages over securities. The IRS Form 6781 allows investors to split their capital gains on Schedule D, with 60 percent taxed at the lower long-term capital gain rate. Forty percent is taxed on ordinary and short-term capital gains.

Section 988

The IRS enacted Section 988 as a way to tax corporation that earns money from foreign exchange rate fluctuation as part of their core businesses. Under Section 988, such gains and losses are filed and treated as interest income or expenses for tax purposes. They are not liable to receive the favorable 60/40 split.

The Taxation of Foreign Exchange Markets Trades

Ali Qamar

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