If you day trade currencies, the tax laws that apply to you can be confusing, and there are gray areas. How taxes apply to you can be impacted by the following:
Whether you’re an individual or a business: Small individual currency transactions are usually considered to be like-kind exchanges; for example, if you go on vacation to Mexico, exchange your dollars to pesos when the dollar is strong and then change whatever remains back at the border a week later when the dollar is a bit weaker, you’ll have made a profit.
However, the vacation transaction is not a reportable one, because, in essence, you exchanged two identical items: money for money. A business, however, can accrue taxable gains and losses due to changes in exchange rates.
If a company makes goods in the United States and sells them through its Mexican subsidiary, for example, the amount of profit or loss that the subsidiary has depends on the exchange rate between the dollar and the peso, and that determines the amount of tax that the company pays. In this case, identical objects aren’t being exchanged.
The IRS has plenty of rules on how businesses should handle foreign exchange under Section 988 of the tax code.
Whether you’re trading actual currency or futures and option on currencies: Futures and options on currencies are taxed under Section 1256 using the handy 60/40 Rule described in the preceding section. But you’re trading in the spot market. You aren't trading currency contracts; you are trading actual currency. What do you do about profits and losses you may accrue?
The IRS isn't keen on your claiming a tax-free like-kind exchange if your goal is to make a living trading currencies. But you aren't running a business with overseas operations, are you? Unfortunately, there are no clear guidelines here, so you probably want to work with an accountant.
The general thought is that you can report your currency trading through Section 988 or Section 1256. Under Section 988, your trading gains and losses are considered short-term capital gains in your trading business. This would save you money if you lost money trading but cost you if you made money.
Under Section 1256, your spot trading is handled as futures contracts, and you pay short-term capital gains taxes on 40 percent of your profits and long-term capital gains taxes on the remaining 60 percent of your profit. This would save you money in the years you made money.
The key? Be consistent. You can't file under Section 988 when you lose money and under Section 1256 in years you make money. That game makes the IRS very unhappy, and you don't want to have the tax guys unhappy with you.
Although you should consider this as a guideline and not professional tax advice, this warning holds particularly true for the information on currencies. Both the Commodity Futures Trading Commission and the Internal Revenue Service are taking a close look at the forex market to clarify the regulations, so the information may be very different when you do your taxes.
