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November 18, 2024

Treat Profits as Ordinary Income with Section 988

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Wondering What Happens When You Withdraw Forex Profits?

Here’s a quick guide to understanding how the U.S. government views gains on foreign exchange to help you avoid misunderstandings with the IRS.

FTC Disclaimer

This article consists of personal opinions and should not be considered legal, tax, investment, financial, or other advice. Taxes are extremely complex and specific to individual situations; consulting a registered CPA before taking any action is highly advised.

How the U.S. Government Views Your Profits

Similar to trading stocks, taxation is dependent on the time horizon of the investment (even scalping is considered a form of investing). However, forex is not subject to the same regulations as the stock market. Forex traders may qualify for classification under two seperate sections of the U.S. tax code: IRC Section 1256 or IRC Section 998. Depending on your situation you may elect either classification to benefit from reduced tax liability.

Section 998

Spot traders are automatically considered under Section 998 due to the short-term nature of individual investments. The extent of the information shared with the CloverBloom Communtiy is considered "spot trading" as these trades are dependent on "spot" or otherwise current market price and closed within relatively short-term horizions. Under Section 998 profits are treated as ordinary losses and gains.

An ordinary loss is fully deductible to offset taxable income where there is no limit for ordinary losses. This is different to a "capital loss" (selling a stock at a loss) of which taxpayers are only allowed to deduct capital losses (money lost on stock) from taxible income of up to $3,000. You however, cannot carry over these losses and are only deductible in the year those losses were realized.

Ordinary gains are taxed as normal income. You will pay the full tax liability on your profits, just as you would on a wage or salary. However, this is not done for you. Your tax liability is not estimated and deducted ahead of time, such as when you recieve payment from an employer. You will be required to maintain records of your realized losses and gains and responsible to send a check to the IRS (for the correct ammount) when taxes are due.

For these reasons, please do not base your taxes off of this article. Consulting a registered CPA is always advised.

Nothing is certain except death and taxes

Section 998 vs. Section 1256

Should you end the year with a net gain, you may choose to reclassify under Section 1256. The reason for this is the 60/40 tax consideration on profits, meaning the first 60% of gains are considered long-term capital gains and the remaining 40% as short-term capital gains (ordinary income).

This is the preferred option for traders in higher tax income brackets. Within the U.S. the max tax rate is currently 37% on ordinary income and 20% on long-term capital gains.This classification must be elected at the beginning of the year by your accountant. Consulting a registered CPA is the best option for deciding which to elect.

If this is your first year paying taxes on profits from forex trading, you may be eligible to elect either classification after the start of the year.

% of gains or losses taxed as tax rate
first 60% long-term capital gains or losses at 20%
remaining 40% short-term capital gains or losses up to 37%

Taxation Checklist

A rough outline of what you may need to consider.

  1. Maintain clear records of gains and losses for the year (regardless of net profit or loss)
  2. Consult a registered CPA before taxes are due.
  3. Fully disclose your tax situation regarding all forms of income.
  4. Deduct ordinary losses from taxible income.
  5. Calculate the amount owed to the IRS based on your elected classification.
  6. Send the IRS a check every year for the proper amount.

The Bottom Line

Forex profits are not tax-free. Any attempt to evade taxes could lead to exorborant penalties that will likely far exceed what was originally owed. I am not a registered CPA or suggesting this information is accurate. The intent of this article is to better inform my community of the potential tax liabilities they may be subject to. In the long-run, understanding and properly paying your taxes will likely be far cheaper than alternative methods.

Main Points

  • You may be taxed under IRC Section 998 or Section 1256
  • Section 998 treats profits from forex trading as ordinary income.
  • You may elect either classification to reduce liability.
  • This must be announced at the start of the year.
  • If this is your first year, you may do so after the start of the year.
  • You may claim an unlimited amount of deductions from ordinary losses.
  • You can only claim these decductions in the year they were realized.
  • Ordinary gains are taxed as ordinary income.
  • Always consult a registered CPA before taking any action.

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