John Russell: Adam, what is the most important basic advice you can give to forex traders when it comes to their taxes?
Adam Kelsey: The most important advice to give forex traders is to be proactive regarding their taxes. If they are making a profit on their trading they need to make sure they are making quarterly estimated tax payments and they need to contact their tax professional prior to the end of the year for tax planning ideas.
JR: How should forex gains/losses be reported on a tax return?
AK: There are two methods to reporting gain/loss from buying and selling the actual currencies themselves. The first method is the default rule as defined by section 988 of the Internal Revenue Code. This code section states that the trading of the currencies themselves is taxed as ordinary income which is similar to interest income. The second method of reporting gains/losses from trading forex is treating the gains/losses as 1256 contracts. This method is only available to those who properly elect to opt out of the regular section 988 treatment as defined by the code.
JR: What type of records should forex traders be keeping during the year for tax purposes?
AK: Forex traders should be keeping accurate records of the trading activity and the gain/loss generated. Also, for those traders who elect to opt out of section 988 treatment they will need to keep the proper election records as defined by the code.
JR: What should forex traders expect from their brokers when it comes to tax issues?
AK: Each broker is different in what information they will provide to their clients and in what format. Many, forex brokers will provide details regarding the trading activity, the actual gain/loss realized and the floating gain/loss. However, when it comes to issues regarding how the gain/loss is reported, the brokers will generally ask their clients to speak to their tax professionals.
JR: What is the number one thing you would warn forex traders to avoid doing on their tax return?
AK: The number one issue is to not report the gain/loss on the wrong part of the income tax return. There is a significant difference between reporting the gain/loss as other ordinary income and as 1256 contracts. If the trader has not properly elected to opt out of section 988, files on Form 6781 as 1256 contracts and is later audited they could possible face significant interest and penalties for additional tax due. Likewise if the trader has properly elected to opt out of section 988 and files as other ordinary income they could be losing a significant tax benefit.
JR: Adam, I appreciate the that you spent answering these questions. Forex traders will really appreciate this basic help on forex tax issues.
As always, I recommend that you do your own research. Handle your taxes the same way you handle your trading. Research until you feel confident in your decisions. If you feel that you are in over your head, do not hesitate to contact a professional like Adam. Taxes are not a smart place to get creative.