Reporting FX Gains and Losses for US Taxes
Foreign currency gains and losses receive special tax treatment under the Internal Revenue Code. The default rule under Section 988 treats most forex gains as ordinary income—taxed at your marginal rate up to 37%—while Section 1256 provides favorable 60/40 capital gains treatment for regulated futures contracts. Understanding which rules apply, when elections are available, and how to report correctly can significantly affect your after-tax returns. A $10,000 forex gain could generate tax liability ranging from $1,200 to $3,700 depending on classification and your tax bracket.
Section 988: The Default Rule for Forex
Section 988 governs "foreign currency transactions" and applies automatically to most retail forex trading, foreign currency denominated bank accounts, and foreign currency contracts entered in the ordinary course of business.
What qualifies as a Section 988 transaction:
- Spot forex trades through retail brokers
- Forward contracts and foreign currency swaps
- Foreign currency denominated debt instruments
- Foreign bank account balances and conversions
Tax treatment under Section 988:
| Characteristic | Treatment |
|---|---|
| Gain/loss character | Ordinary income/loss |
| Tax rate | Marginal rate (up to 37% federal + state) |
| Loss limitations | Ordinary losses offset ordinary income (no $3,000 capital loss limit) |
| Wash sale rules | Do not apply (Section 988 transactions are not "securities") |
| Reporting form | Form 4797 or as "other income" on Form 1040 |
Advantage of Section 988: Losses are fully deductible against ordinary income in the year incurred. If you lose $20,000 in forex trading, you can offset $20,000 of wages, interest, or other ordinary income—no capital loss carryforward required.
Disadvantage of Section 988: Gains are taxed at ordinary rates. A $50,000 gain for someone in the 35% bracket generates $17,500 in federal tax versus $10,000 (20% long-term rate) if treated as capital gains.
Example calculation:
Taxpayer in 32% federal bracket + 5% state = 37% combined rate
| Trading Result | Section 988 Tax | If Capital Gains (hypothetical) |
|---|---|---|
| $10,000 gain | $3,700 | $1,500-2,380 (depending on holding period) |
| $10,000 loss | -$3,700 (tax savings via deduction) | -$3,000 offset + carryforward |
Section 1256: 60/40 Treatment for Regulated Futures
Section 1256 applies to specific types of contracts traded on regulated exchanges, providing favorable blended tax treatment regardless of holding period.
Contracts covered by Section 1256:
- Regulated futures contracts (including currency futures on CME)
- Foreign currency contracts on qualified boards of trade
- Non-equity options on broad-based indices
- Dealer equity options
Key feature: 60/40 treatment
Gains and losses are treated as:
- 60% long-term capital gain (taxed at 15-20% for most taxpayers)
- 40% short-term capital gain (taxed at ordinary rates)
Blended rate calculation:
For a taxpayer in the 35% ordinary income bracket with 20% long-term capital gains rate:
Blended rate = (60% × 20%) + (40% × 35%) = 12% + 14% = 26%
Compare to pure ordinary income at 35%: 9 percentage point advantage
Mark-to-market requirement:
Section 1256 contracts are marked to market at year-end—unrealized gains and losses are recognized as if you sold and repurchased on December 31. This eliminates timing flexibility but ensures consistent treatment.
Example: EUR/USD futures traded on CME
| Transaction | Treatment |
|---|---|
| Buy 2 EUR futures March 15 at 1.0800 | |
| Sell 2 EUR futures July 20 at 1.1050 | |
| Gain: (1.1050 - 1.0800) × €125,000 × 2 = $6,250 | Section 1256: 60/40 treatment |
Tax on $6,250 gain (35% ordinary / 20% LTCG bracket):
- 60% × $6,250 × 20% = $750
- 40% × $6,250 × 35% = $875
- Total tax: $1,625 (effective rate: 26%)
Same gain under Section 988: $6,250 × 35% = $2,188
Savings from Section 1256: $563
Election Options and Deadlines
Electing out of Section 988 (opting for capital gain treatment):
Taxpayers can elect to treat forex gains and losses as capital gains/losses instead of ordinary income under Section 988(a)(1)(B). This election:
- Must be made before entering the transaction (contemporaneous identification)
- Applies to all qualifying transactions for the year (cannot cherry-pick)
- Must be maintained in your records (no IRS form required)
- Is irrevocable once made for that tax year
When to consider the election:
| Scenario | Recommendation |
|---|---|
| Expecting net forex gains | Elect out (get capital gains treatment) |
| Expecting net forex losses | Stay in Section 988 (ordinary loss deduction) |
| Uncertain | Section 988 default may be safer (unlimited loss deduction) |
Practical challenge: You must make the election before knowing whether you'll have gains or losses. Most retail traders don't bother with the election because predicting annual results is difficult.
Section 1256 election (for forward contracts):
Currency forward contracts can qualify for Section 1256 treatment under specific conditions. The contract must be:
- Entered on a qualified board of exchange, OR
- Traded in the interbank market with terms similar to exchange-traded contracts
Record-keeping requirements:
If electing out of Section 988:
- Create a written statement identifying the election
- Date the statement before the first transaction
- Maintain records showing the election was made contemporaneously
- Apply consistently to all covered transactions
Form 8949 and Schedule D Reporting
Section 988 transactions (default treatment):
Report aggregate forex gains/losses as "Other Income" on Schedule 1 (Form 1040), Line 8z. Some taxpayers use Form 4797, Part II for foreign currency gains.
Section 1256 contracts:
Report on Form 6781: Gains and Losses from Section 1256 Contracts and Straddles
Form 6781 structure:
- Part I: Report net gain or loss from Section 1256 contracts
- Line 1: Net gain or loss for the year
- Line 2-7: Calculate 60/40 split
- Transfer to Schedule D
Schedule D integration:
| Source | Goes To |
|---|---|
| Form 6781 Line 7 (60% LTCG) | Schedule D, Line 11 |
| Form 6781 Line 8 (40% STCG) | Schedule D, Line 4 |
Capital gain/loss treatment (if elected out of 988):
Use Form 8949 to report individual transactions:
- Part I: Short-term (held ≤1 year)
- Part II: Long-term (held >1 year)
Include:
- Description: "Forex - EUR/USD" or similar
- Date acquired
- Date sold
- Proceeds
- Cost basis
- Gain/loss
Wash Sale Considerations
Key distinction:
Wash sale rules under Section 1091 apply to "stock or securities." The IRS has not definitively ruled whether forex positions constitute securities for wash sale purposes.
Practical positions:
| Transaction Type | Wash Sale Applicability |
|---|---|
| Section 988 forex (retail) | Generally not subject to wash sales |
| Currency ETFs (FXE, UUP) | Subject to wash sales (these are securities) |
| Currency futures (Section 1256) | Unclear; conservative approach applies rules |
| Forex options | Depends on underlying and exchange |
Conservative approach:
If you close a losing forex position and reenter within 30 days, wash sale rules may apply if:
- The position involves a currency ETF or ETN
- The IRS challenges your treatment
- Your broker reports wash sale adjustments
Practical guidance:
- For retail spot forex under Section 988: Most practitioners do not apply wash sales
- For currency ETFs: Apply wash sale rules (these are clearly securities)
- For futures: Mark-to-market eliminates most wash sale issues (positions are closed yearly)
Worked Example: Complete Tax Calculation
Scenario: Sarah is a US taxpayer in the 32% federal bracket. During 2024, she has:
- Retail forex trading: Net gain of $8,000 (EUR/USD spot through retail broker)
- CME currency futures: Net gain of $12,000 (EUR futures)
- Currency ETF (FXE): Net loss of $3,000 (held 8 months)
Tax treatment by category:
| Item | Classification | Treatment |
|---|---|---|
| Forex $8,000 gain | Section 988 | Ordinary income |
| Futures $12,000 gain | Section 1256 | 60% LTCG / 40% STCG |
| ETF $3,000 loss | Capital loss | Short-term (held <1 year) |
Calculation:
1. Section 988 forex gain: $8,000 × 32% = $2,560 federal tax
2. Section 1256 futures gain:
- 60% LTCG: $7,200 × 15% = $1,080
- 40% STCG: $4,800 × 32% = $1,536
- Total: $2,616
3. ETF capital loss: $3,000 short-term loss offsets:
- First: Any short-term gains (the 40% portion of 1256 = $4,800)
- Net STCG after offset: $4,800 - $3,000 = $1,800
- Revised 40% STCG tax: $1,800 × 32% = $576
Revised Section 1256 tax: $1,080 (LTCG portion) + $576 (revised STCG) = $1,656
Total federal tax: $2,560 + $1,656 = $4,216
Comparison: If all were Section 988: ($8,000 + $12,000 - $3,000) × 32% = $17,000 × 32% = $5,440
Section 1256 savings: $1,224 (22% lower tax)
FX Tax Reporting Checklist
Before filing, verify:
Classification:
- Identify each forex transaction type (spot, forward, futures, ETF)
- Determine applicable section (988, 1256, capital gains)
- Review any elections made during the year
Documentation:
- Broker statements for all forex accounts
- 1099-B from futures brokers (shows Section 1256 gains)
- Records of any Section 988 elections
Form preparation:
- Form 6781 for Section 1256 contracts
- Form 8949 for capital transactions (if elected out of 988)
- Schedule D summary
- Schedule 1 for Section 988 ordinary income/loss
Special situations:
- Foreign bank accounts: Report FX gains when converting to/from USD
- FBAR filing if foreign accounts exceed $10,000 aggregate
- Form 8938 (FATCA) for foreign financial assets above thresholds
Professional consultation triggers:
- Total FX gains/losses exceed $25,000
- Complex election decisions (multiple transaction types)
- Prior year carryforward losses affecting current treatment
- Mixed positions (hedging with offsetting gains/losses)
Important note: Tax rules are complex and subject to interpretation. Consult a tax professional for specific situations, especially with significant forex activity or when considering elections between Section 988 and capital gain treatment.