How Are Forex Gains Taxed?

How Are Forex Gains Taxed?

  • Posted on 0808-0404-2022
  • by Gareth McCauley

Whether it’s the high liquidity or the low transaction costs, plenty of benefits convince people to jump into forex trading. However, many aspiring traders forget to consider how taxation works when buying or selling forex.

In today’s article, let’s go over the basics of forex taxes and how gains are taxed.

The Basics of Forex Taxes

When it comes to forex trading, traders need to pay tax on capital gains every time they can sell a given security at a higher price than the original purchase cost. Capital gains is the term used to refer to the increase in value of an asset when it’s sold.

When a forex trader makes a capital gain, they are considered taxable. Meanwhile, traders are not expected to pay any taxes for trades that have earned payouts or capital gains.

The specific capital gains tax rate largely depends on the country the trader is trading. The following are the maximum capital gains tax rate for some countries:

  • United States (37%)
  • Sweden (30%)
  • Japan (20.315%)
  • China (20%)
  • United Kingdom (20%)
  • Germany (25%)
  • Spain (23%)
  • Greece (15%)
  • Russia (13%)
  • Switzerland (0%)

It’s worth noting that some countries like Russia don’t have a separate tax rate for capital gains earnings. Some countries have effective tax rates that are significantly lower. However, they typically depend on the total annual income of the individual (trader) and other country-specific circumstances.

Section 1256 Tax Law

The Internal Revenue Service (IRS) essentially has two primary types (sections) of taxes applied to forex traders. That’s section 1256 and section 988.

Section 1256 is a 60/40 capital gains tax treatment and is generally considered by most traders as the most common way to file forex profits. Under section 1256, 60% of the total gains are taxed at 15%.

The 40% is taxed based on the trader’s current income bracket. In the case of an American trader, the 40% can be taxed for as high as 37%.

Many profitable traders prefer to report under section 1256 because it’s the option that offers a more significant tax break. The 60/40 tax treatment is also highly favourable for traders within the high-income tax brackets.

Section 1256 does have one major drawback. The total amount of losses that a trader can claim is capped at around $3,000 per year. When a trader suffers a net loss of $10,000 per year, they can only reduce their taxable income by $3,000.

how is forex taxed

Section 988 Tax Law

Section 988 is an alternative to section 1256, where most gains from forex transactions are treated as ordinary income. Regardless of whether an individual trader or a corporation earns the capital gains.

Since this section treats forex trading as an ordinary taxable income, traders will only pay for their payouts depending on their tax bracket. Here’s the US 2020 tax bracket:

TAX RATESINGLE FILERS / MARRIED FILING SEPARATELY ($)MARRIED FILING JOINTLY ($)HEAD OF HOUSEHOLD ($)
10%0 – 9,8750 – 19,7500 – 14,100
12%9,876 – 40,12519,751 – 80,25014,101 – 53,700
22%40,126 – 85,52580,251 – 171,05053,701 – 85,500
24%85,526 – 163,300171,051 – 326,60085,501 – 163,300
32%163,301 – 207,350326,601 – 414,700163,301 – 207,350
35%207,351 – 518,400414,701 – 622,050207,351 – 518,400
37%518,401 and above622,051 and above518,401 and above

 

It’s important to keep in mind the standard deduction rate for single and married individuals. Individual filing is $12,400, while married filing (joint filing) is $24,800. A single trader with an annual income of $50,000 will need to have it deducted by $12,400, making it $37,600. That means the trader falls within the 12% bracket.

One major benefit of being taxed according to section 988 is that traders can use the total of their net losses to reduce their taxable income. Unlike section 1256, reducing taxable income isn’t capped at $3,000 per year.

That’s why losing traders and most spot traders prefer section 988. There are no capital-loss limitations. That will help any trader take advantage of trading losses to reduce the taxable income.

Familiarize Yourself with the Taxes

Whether you’re simply trying out Forex trading or fully committed to making it a career, it’s in your best interest to familiarize yourself with how taxation works. Doing so will help you better understand how trading works and help you deal with potential tax issues easier.

Understanding how taxation works can help you file them correctly and save you thousands of dollars in taxes.

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