Forex Tax - A New Approach

IRS Notice 2007-71 (established Aug. 27, 2007) reverses IRS Notice 2003-81.
IRS Notice 2007-71 narrowly (yet definitively) addresses the tax treatment for "over-the-counter currency options," stating they may no longer be treated as "foreign currency contracts" in IRC 1256 (with lower 60/40 tax rates); instead they are part of IRC 988 (ordinary gain or loss).

Notice 2007-71 entirely reverses IRS Notice 2003-81, which had ruled that OTC currency options (on major currencies) are "foreign currency contracts" in IRC 1256 (with 60/40 tax treatment). Relief was provided for this change.

Although both of these IRS Notices appear narrow in scope - addressing OTC currency options, which are just one of many types of currency vehicles to trade - both notices have much greater implications on the current state of forex tax law.

Even after 2007-71, forex tax law remains too vague and confusing for most traders and brokers.

Retail spot forex traders are different from professional forward forex traders.
The forex Interbank market has been around for many decades. Robert A. Green founded Green & Company CPAs in 1983 to handle the special tax and accounting needs of several leading professional forex traders and Interbank brokers (they used phones only before the Internet).

It's important to understand some key differences between professional forex traders and this newer breed of online forex traders.

Professional forex traders often trade "forward contracts" (rather than spot forex) because forwards have more transparency and better pricing than spot. Most professional traders in forward forex understand they are trading major currencies (for which regulated futures contracts [RFCs] exist); therefore they can claim IRC 1256 60/40 tax treatment.

Most professional forward forex traders make a good living trading forwards and they count on lower 60/40 tax rates each year (up to 12-percent lower tax rates). Remember, IRC 1256 losses may be carried back three tax years, but only applied against IRC 1256 gains in those years.

Contrast professionals with the newer breed of online forex trader. Most online forex traders are new to forex; some moved from the online securities or futures trading space. Many have very low account sizes ($2,000 to $25,000) and they lack the capital, clout and connections to trade forwards in the (non-retail) Interbank market.

The retail online forex trading marketplace did not pick up steam until the early 2000s. When the 1990s online trading revolution in securities suffered a bear market, brokers and traded morphed into the forex market. This became possible when larger banks democratized Interbank market access with new retail platforms.

The key difference is that online forex traders mostly trade spot contracts, whereas professional traders have access to lower-priced forward contracts. But are spot and forward forex contracts treated the same?

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 on this page for content updates and join our e-mail list (at the bottom of this page) to receive email notification.

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 vs. 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 see 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 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.

A summary view of forex tax after Notice 2007-71
Look at it this way.

Spot forex in uncertain. See details above.

Forward forex in uncertain. See details above.

Currency futures are "regulated futures contracts" in IRC 1256 by default.

OTC currency options are IRC 988 and they are barred from IRC 1256 (Notice 2007-71).

There are also elections to "opt-out"
There are various elections to "opt out" of IRC 988 and IRC 1256, which can serve to navigate again between the two tax treatments.

IRC 988 allows a trader (but not a manufacturer) to "opt out" of IRC 988 ordinary gain or loss treatment into capital gains treatment. This is referred to as the "capital gains" election. If a trader has large capital-loss carryovers, they may want their forex gains to be capital gains (rather than ordinary gains) in order to use up their capital-loss carryovers. Conversely, if an investor (lacking trader tax status) has large forex losses generating net taxable losses, their forex ordinary losses can be permanently wasted. With the capital gains election, they can covert wasted ordinary losses (not allowed for NOL since they are not business traders) into useful capital loss carryovers.

As indicated above, a trader may elect out of IRC 1256 into IRC 988.

Have your cake and eat it too.
Both pre- and post-Notice 2007-71, we continue to think it's possible for most forex traders to get the best of both (tax) worlds: ordinary loss treatment on spot and forward forex trading losses (rather than capital-loss limitations), and IRC 1256 lower 60/40 tax rates on forward forex contracts (and maybe spot forex, too, with more aggressive interpretations of the law - see above).

IRC 988 vs. IRS 1256 tax treatment.
IRC 988, by default, has ordinary gain or loss treatment. Losing traders prefer IRC 988, since it does away with capital-loss limitations, allowing full ordinary loss treatment against any type of income.

IRC 1256, by default, has lower 60/40 capital gains tax rates. Profitable traders prefer IRC 1256, since it reduces their tax rates on trading gains. IRC 1256 has a three-year carryback feature, but only against 1256 gains in those years.

More about the intentions of Congress and the IRS.
In lay terms, Congress realized that trading in the forex market resembled trading in the currency futures markets and that currency traders often traded both forex and futures in one coordinated trading program.

It would be wrong, confusing and open the door to tax cheating, to only allow ordinary gain or loss treatment on forex and 60/40 tax treatment on futures. This is the reason Congress added "foreign currency contracts" to IRC 1256 - to allow for navigation between IRC 988 and IRC 1256. Hedging forex with futures and vice versa can also tie IRC 988 and 1256 together.

IRC 988 must remain in tact as well, as it mostly applies to manufacturers, global corporations, and hedgers of those businesses. Hence, the continued conflicts remain in IRC 988 and 1256.

Congress gave the IRS the right to figure out tax reporting abuse and to bar certain instruments from coveted IRC 1256 60/40 treatment. This is exactly what happened with the IRS Notices 2003-81 and 2007-71. Notice 2003-81 was issued to combat tax cheating and the Service applied a literal reading of foreign currency contracts. 2007-71 later corrected 2003-81 and unfortunately it barred OTC currency options from 60/40 treatment.

History of IRC 1256 on "foreign currency contracts"
The definition of Section 1256 contracts includes certain forward contracts for the future delivery of foreign currency:

"A forward contract is similar to a futures contract in that it contemplates delivery of a specified quantity of goods, at a specified price, at some specified date in the future. Forward contracts differ, however, because they are private contracts in which the parties remain entitled to performance from each other. No organized market or established mechanism is available for terminating a taxpayer's position prior to the delivery date, as in the case of futures. In addition, the terms of a forward contract are usually not standardized, and forward contracts, unlike futures, do not typically involve mark-to-market procedures or margin requirements (although contract parties may agree on such measures amongst themselves)."

Informally, the IRS has indicated that it refers to "the OTC market maintained by banks to purchase and sell foreign currency and financial products," and noted that "Congress intended to include within the definition of a foreign currency contract bank forward contracts in currencies that are [also] traded through RFCs because bank forward contracts are economically comparable to and used interchangeably with RFCs." FSA 200025020 (June 23, 2000).

"Before ERTA (older tax law) was enacted, the tax consequences of trading in forward and futures contracts were basically the same. The ERTA regime, however, created disparity in the tax treatment of the instruments given that Section 1256 only applied initially to RFCs (regulated futures contracts), not to forward contracts. Congress subsequently came to view forward contracts as being economically comparable to, and traded interchangeably with, RFCs despite the differences noted above. The volume of trading through forward contracts in foreign currency was substantially greater than foreign currency trading on futures exchanges, and forward currency prices were readily available. Accordingly, in order to eliminate the disparity created by ERTA, the scope of Section 1256 was expanded in 1982 to encompass the foreign currency contracts described below."

"As added to the Code in 1982, Section 1256(b)(2) provides that a foreign currency contract constitutes a Section 1256 contract. Under Section 1256(g)(2)(A), a foreign currency contract is any contract that meets three requirements. First, the contract must require delivery of a foreign currency in which positions are also traded through RFCs (or alternatively, the contract must contemplate a settlement that depends on the value of such a traded currency). Currently (this old statement is no longer true), only a handful of currencies are traded through RFCs, including the Canadian dollar, British pound, Japanese yen, Swiss franc, and German mark (pre-Euro). Other actively exchanged currencies are not so traded, and as a result, forward contracts involving those currencies are not subject to Section 1256 (e.g., Italian lire)." Our comment: This list of currencies is dated and it has greatly expanded to all the major currencies over the years, so a case can be made that most spot forex has RFCs traded in those same currencies.

"In IRS Field Service Advice Memorandum 200025020, the Service, after noting the lack of a definition of the 'interbank market' in the statute, offered the following guidance:

"The interbank market refers to the OTC market maintained by banks to purchase and sell foreign currency and financial products. The interbank market is not a formal market, but rather a group of banks holding themselves out to the general public as being willing to purchase, sell or otherwise enter into certain transactions. The Service broadly interprets the interbank market to include all banks and investment banks (as the terms are generally used in the marketplace).

"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!