U.S. Income Tax Strategies for Forex and Futures Profits & Losses

Upon becoming profitable, traders should begin to think about the most advantageous income tax strategy to use. The written and signed statement in the above image is a redacted copy of my actual U.S. IRS Code Section 1256 Election. For income tax purposes in the U.S., forex profits and losses are lumped in with futures profits and losses in terms of tax treatment. As a default provision (where the taxpayer makes no election), IRS Code Section 988 will be applied to futures and forex profits and losses. Pursuant to Section 988, all such profits will be taxed as ordinary income and all such losses will be deductible as ordinary losses. However prior to the start of a trading/tax year, a forex and/or futures trader is allowed to opt out of Section 988 and into Section 1256.

Why did I elect into Section 1256? Because even if I had been scalping in 2022, I was entitled to a 60/40 split of profits. 60% of profits are treated as long-term capital gains, while 40% of profits are treated as short-term capital gains. In the U.S., the maximum long-term capital gains tax rate is 20%. So, that's a 20% or less tax rate applied to most of the profits and the ordinary tax rate (generally higher) applied to less of the profits. As a caveat, Section 1256 only allows a maximum of 3000 USD of total losses to be deducted.

Although the election must be made before any trade is placed within the tax year at issue, that election only need be memorialized internally. Whether a given taxpayer is a commodity pool operator or a sole proprietor (like most retail traders), it's a very good idea to draft, sign, date, and get witnessed, a formal statement. The above document can be used as a template for readily drafting such a statement. It's no coincidence that the above Election is dated December 31, 2021. Again, the Election need not be filed with any governmental agency, but the taxpayer should keep it safely stored in case of an IRS audit, etc. If the taxpayer files a tax return via software, that software will likey ask a simple question about electing out of 988 upon entering trading profits.

Essentially, a trader must estimate her/his likelihood of profitability in advance of any given trading/tax year. Obviously, this is much easier for a trader who is continuing to employ a profitable strategy from a prior year... or at least, trading a quantified and empirically tested strategy. Conversely, a trader who is not yet profitable has little incentive to opt into Section 1256. Of course, the IRS Standard Deduction must also be considered... especially by traders in lower ordinary tax brackets.

Nothing in this post may be construed to be legal nor tax advice. The author is not a licensed tax attorney nor a certified public accountant. For any and all questions and/or concerns regarding legal and/or tax advice for your specific tax situation, you must consult a licensed and/or certified tax professional in your specific jurisdiction.

(https://www.mql5.com/en/blogs/post/756757)

JohnnyRy wrote: Tue May 21, 2024 9:10 am
(https://www.mql5.com/en/blogs/post/756757)

1256 in the long run saves you more money and i think you cant change which one you choose once you pick

WOLF wrote: Tue May 21, 2024 9:38 am 1256 in the long run saves you more money and i think you cant change which one you choose once you pick

Your first point is absolutely correct for profitable traders, but anyone can change their election by drafting and executing an internal Section 988 election in a subsequent year by using the same timing... and then simply electing it at tax time.

Canada...

"If a trader is trading forex for personal purposes, such as to supplement their income or as a hobby, any profits earned from forex trading will be considered capital gains. Capital gains are taxed at 50% of the individual’s marginal tax rate. This means that if an individual’s marginal tax rate is 30%, they will only pay tax on 50% of their capital gains.

However, if a trader is trading forex as a business, any profits earned will be considered business income. Business income is taxed at the individual’s marginal tax rate. This means that if an individual’s marginal tax rate is 30%, they will pay tax on 100% of their business income.

To determine whether forex trading income is considered capital gains or business income, the CRA looks at a number of factors. These factors include the frequency and duration of the trading activity, whether the trader has a separate office or workspace for their trading activities, and whether the trader has a business plan or strategy for their trading activities.

It is important for traders to keep detailed records of their trading activities, including profits and losses, to accurately report their income to the CRA. Traders should also consult with a tax professional to ensure they are following all tax rules and regulations.

In addition to income tax, forex traders may also be subject to other taxes, such as the goods and services tax (GST) or the harmonized sales tax (HST). Traders who earn more than $30,000 in a year from their forex trading activities may be required to register for and collect GST or HST.

Forex traders should also be aware of the foreign income verification statement (T1135) that must be filed with the CRA if they have foreign assets with a total cost of more than $100,000 CAD. This includes any foreign currency or forex accounts held outside of Canada."

(https://www.forex.academy/how-does-inco ... in-canada/)

Might be of interest to some is the UK model that has CFDs and 'Spread Betting' which are essentially the same thing but with different tax laws.

The broker IG started a gold spread betting service immediately after the Bretton Woods agreement in 1974 allowed public trading in gold (other assets came later). So rather than own actual gold punters could bet on gold price movements using a sports betting model and this all came under the gaming commission jurisdiction and so was tax free.

CFDs were created in the 1990s primarily as a means to hedge asset holdings. So asset holders could take out a low cost CFD which could cover the loss of their asset if price dropped. If the price went up as expected then the loss on the CDF could be set against the tax on the profit gain of the principle asset.

Spread Betting companies saw that SB could easily be transitioned to a CFD platform and still remain in the gaming jurisdiction. So in the UK we have Spread Betting which is non-taxable and CFD trading which is taxable though both operating on a near identical platform.

Ogee wrote: Tue May 21, 2024 5:40 pm Might be of interest to some is the UK model that has CFDs and 'Spread Betting' which are essentially the same thing but with different tax laws.

The broker IG started a gold spread betting service immediately after the Bretton Woods agreement in 1974 allowed public trading in gold (other assets came later). So rather than own actual gold punters could bet on gold price movements using a sports betting model and this all came under the gaming commission jurisdiction and so was tax free.

CFDs were created in the 1990s primarily as a means to hedge asset holdings. So asset holders could take out a low cost CFD which could cover the loss of their asset if price dropped. If the price went up as expected then the loss on the CDF could be set against the tax on the profit gain of the principle asset.

Spread Betting companies saw that SB could easily be transitioned to a CFD platform and still remain in the gaming jurisdiction. So in the UK we have Spread Betting which is non-taxable and CFD trading which is taxable though both operating on a near identical platform.

Well said, Ogee.

It's rather ironic that spread betting was invented in the US and then banned in the US. I don't know whether CFD's ever even got off the ground in the US because CFD's are banned in the US too. I'm amazed to learn that the UK imposes no tax on gambling prizes. If these instruments were legal in the US, they would generally carry a 50% prizes and awards tax liability.

Also, I formerly traded with IG US and I joined their in-house discussion forum. After seeing other overseas forum members posting about massive slippage and rejected trades, I warned them that spread betting and CFD dealers are basically casinos because they are not connected to any interbank market and hence, not connected to any greater liquidity pool. I went on to say that when a trader places an order with a spread betting or CFD dealer, a sufficient number of other traders must be participating with that specific dealer in order for that order to execute efficiently--if the number of in-house participating traders is insufficient, massive slippage and rejects result. The high intraday volatility of CFD's may appear very attractive at first, until we realize that the cause of it is low liquidity.

I should note that the aforementioned IG forum was hosted and maintained by IG UK. They obviously did not take kindly to my knowledge spreading because they immediately banned all US traders from their forum in response.

JohnnyRy wrote: Wed May 22, 2024 1:41 am

I should note that the aforementioned IG forum was hosted and maintained by IG UK. They obviously did not take kindly to my knowledge spreading because they immediately banned all US traders from their forum in response.

Very true as you say about matching trades in house and slippage. It's important to differentiate between the 2 basic broker business models. The big brokers like CMC and IG use a very conservative model reason being is that it ensures their survival during Black Swan events. IG has been about for over 50 years and lived through dozens of them.

Using the conservative model they will sort buys and sells and match them up 'in house' as much as possible and then place the excess on the open market. If the excess is buys they take out an equal amount of buy positions so if you win they win, collect the money from their provider and give to you. You lose they lose and take your money and give to the provider. They are not taking on any risk themselves at all, that's how they survive Black Swans. They are only making on the spread but still profit because the spread they get is far better to what they charge you.

The other business model is for the broker simply to take the other side of your bet. You win they lose, you lose they win. This model can allow the broker to some very shady practices as you could imagine and also makes them more vulnerable to Black Swans. Several years ago after the major oil price drop the broker Plus 500 had to tell shareholders there wouldn't be any dividend pay-outs that quarter as unfortunately their punters actually called it right this time on the oil trade which meant major losses for the broker. Even middle sized brokers can go bust very suddenly.

The conservative model is going to be more expensive to operate so these brokers won't be the cheapest, and, as you say, they are likely to have more slippage as they need to find a liquidity provider rather than just quickly taking on your bet themselves. Still, it's all swings and roundabouts, take your pick, take your chances.

Got a free gift from Kenny Lee, Director of Customer Relations at Trading.com (US), who said that he appreciates my business. Scored one for my wife too, of course. This is tiny income for tax time.