FOREX is the foreign exchange market. Individuals and businesses recognize profits and losses when assets and liabilities denominated in foreign currencies fluctuate in value due to changes in the relative value of the foreign and home country currencies and not in the value of the underlying asset or liability. In the United States, taxation of these FOREX transactions can be complicated.
Illustration
FOREX profits and losses are best illustrated through a non-interest bearing bank account. Imagine that an individual in the U.S. deposits $150 in a euro-denominated bank account when the exchange rate is $1.50 U.S. to 1 euro. The individual's bank account therefore has an initial balance of 100 euros. One year later, if the U.S. dollar has depreciated in value and the exchange rate is now $1.55 U.S. to 1 euro, the balance in the bank account is still 100 euros, although the U.S. dollar equivalent value is now $155. The individual has a $5 profit from FOREX. This is just one illustration of how FOREX works.
IRC 988
Section 988 of the Internal Revenue Code (IRC) is the principal section of tax law dealing with the taxation of profits and losses from ordinary FOREX transactions, such as the bank account example illustrated above. Section 988 requires that all economically realized gains and losses from such FOREX transactions be aggregated and treated as "ordinary" income for income tax purposes. The definition of an "economically realized" transaction is complex but typically involves a project or set of transactions that have been substantially completed.
Foreign Debt Securities
Businesses and individuals who hold foreign debt securities may find a portion of their profits or losses taxed under Section 988 as well. Domestic debt securities are taxed as investment income -- with a series of cash flows treated as income and often a capital gain or loss at the maturity of the investment. Holders of foreign debt securities often find they have interest income, capital gain or loss income, and a FOREX profit or loss taxable under Section 988.
Traders
The IRC allows different treatment for certain individuals who make their living by trading FOREX securities. Individuals who qualify for this treatment may be classified as traders and may elect out of taxation under Section 988. Such an election allows traders who deal with FOREX securities described under Section 1256 of the IRC to "mark to market" the FOREX securities, essentially treating each FOREX security as if it were sold at year end.
Reporting Section 1256 Transactions
Traders eligible to opt out of Section 988 treatment and report profits and losses for each FOREX security as if were sold at year end must file Internal Revenue Service (IRS) Form 6781, "Gains and Losses From Section 1256 Contracts and Straddles." This form affords traders preferential tax treatment, allowing them to treat 60 percent of aggregate gains or losses at reduced long-term capital gains rates, and the remaining 40 percent at short-term capital gains rates, taxable at ordinary income rates.
Source - eHow
