How Are FOREX Profits Taxed

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

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The Forex Market Uses Margins to Increase Your Profits

Forex is a nickname for the foreign exchange, a vast market of trading in which the commodity is money itself. In the forex market, traders are buying and selling foreign currencies -- trading dollars for euros, pounds for yen, and so forth.

Forex is profitable because national currencies fluctuate from day to day based on predictions of the nation’s gross domestic product and other factors. As with the stock market, the idea with the forex is to buy low and sell high: Buy a lot of a particular currency when it’s weak, then sell it when it becomes stronger.

For example, bad financial news in Great Britain means that forex traders will be selling off their British pounds as fast as possible, as the pound is about to become devalued. Once the pound recovers, those traders will sell it for something else, thus turning a profit.

Though we talk of “buying” and “selling” pounds, euros, yen and francs, the transactions performed in the forex are not literal. That is, if you want to buy 100,000 euros, you don’t have to withdraw the equivalent U.S. dollars from your bank account and swap them out for a big stack of euros. Everything is done on paper only, though the resulting profits and losses are real.

Because the transactions are not done physically, there is room in the forex for what are called “margins” or “leverage.” Put simply, this means you don’t have to actually put up the full amount of the position you’re taking. Usually the margin is 1%, meaning that when you put $1,000 into it, you’re actually getting $100,000. Of course, margins multiply your losses as well as your profits, so you have to be careful.

One of the reasons for allowing a 100:1 margin like this is that the major world currencies in the forex market usually fluctuate less than 1% a day. (In the stock market, a typical stock might fluctuate as much as 10% in one day.) With changes that small, your daily loss or gain on an initial investment of $1,000 would be almost imperceptible, usually less than $10 either way. By multiplying it by 100, the gains and losses in the forex market are more pronounced.

With leverage implemented that way, the basic “lot” for buying and selling currencies is usually 100,000 (which of course only costs 1,000). Most firms that handle day-trading on the forex market don’t go any lower than that.