Forex Taxes Explained
Traders have to pay tax on capital gains trading Forex when they sell a given security at a higher price than the original cost of purchase. It goes without saying that traders do not have to pay any tax for those trades, where they have earned no payouts. The exact methodology and rate of capital gains tax depends on the specific country. Here is the maximum capital gains tax rate for individuals in some countries:
- United States - 37%
- China - 20%
- Germany - 25%
- Greece - 15%
- Japan - 20.315%
- Russia - 13%
- United Kingdom - 20%
- Switzerland - 0%
- Sweden - 30%
- Spain - 23%
There are several things to keep in mind. Firstly, many countries, including Russia, do not have a separate tax rate for capital gains earnings. Instead, those gains are taxed at the same rate as the personal income tax.
The second important thing to mention here is the fact that those rates, which are shown above represent the maximum capital gains tax rates. In many countries, the effective tax rate on those types of earnings can be much lower, depending on the total annual income of an individual, as well as on other circumstances.
Basics of Capital Gains Tax
So how can one calculate the amount of capital gains tax forex traders should pay to their governments? Well, the accurate calculation of the payable capital gains tax amount consists of two stages.
The first thing traders need to do is to calculate the so-called ‘taxable income’. In the case of the Forex trading, it will be the payout earned after closing each winning trade. For the purpose of a better illustration, let us take a look at this 1-hour EUR/USD chart:
The opening and closing prices are shown by white arrows. As we can see from this chart, by the beginning of the second half of June, the EUR/USD pair was trading near $1.1240 level. Once the pair rose to $1.1335, an individual decided to open a long EUR/USD position, investing $10,000, at 1:10 leverage.
During the subsequent weeks of trading, the Euro has appreciated steadily, rising all the way up to $1.1742 level by the end of July, at which point the trader decided to lock-in gains and close the position. As the chart above demonstrates, the Euro made some additional gains, reaching a $1.19 level. However, this was followed by correction and recently the single currency traded near $1.1760 level.
So in our example, the trader has gained 502 pips. Now, investing $10,000 at 1:10 leverage means that the size of the position will be $100,000, the equivalent of 1 standard lot. At the time of the closing trade, that position would be worth approximately $103,590. In this case, the brokerage company will get its $90,000 loan back and the trader is left with the remaining $13,590.
Since the market participants invested the $10,000 into this trade, the size of the payout for this transaction is $3,590. So for example, if an individual lives in a country where the capital gains tax is fixed at 15%, then a trader has to pay $3,590 x 0.15, which equals $538.5. After paying this amount to the government, the trader can retain the remaining $3,051.50 as his or her net income.
Finally, it is worth noting that traders do not have to make some complex tax calculations after closing every single winning trade. Instead, by the end of the tax year, the brokerage company issues the document, which shows the total amount of gains or losses for the year. Consequently, the market participants can use this number for the purpose of filing their tax returns.
Filing Taxes on Forex Profits Under Section 988
Let us now move on to the question of how to file taxes as a Forex trader in the United States. As mentioned before, in this situation, traders have two options. The first possibility is for traders to file their trading earnings under section 988.
This means that those capital gains will be taxed as ordinary income. Here it is important to understand that the US tax code makes a distinction between the short term and long term capital gains. The tax on the long term capital gains can range from 0% to 20%, depending on the amount of annual earnings.
On the other hand, with section 988, the amounts earned from Forex trading are treated as an ordinary taxable income. So the actual amount the Forex traders will pay for their payouts, does depend on their tax brackets. Consequently, if the trader files his or her earnings under this section, the effective tax rate can range from 0% to 37%. To illustrate this better, let us take a look at this chart, which shows 2020 tax brackets in the US:
Firstly, before starting any calculations, it is important to remember that the numbers displayed above only include taxable income. The fact of the matter is that every US citizen and resident can choose between standard or itemized deductions. The standard deduction for single or married individuals filing separately is $12,400. For married individuals filing jointly, this deduction stands at $24,800.
So for example, if two married people who have $150,000 in combined annual income decide to file taxes jointly and use the standard deduction, then their taxable income will be $100,000 - $24,800, which is $125,200. As we can see from the above chart, they fall into the 22% tax bracket.
However, here it is important to mention that this does not mean that they have to pay 22% on their entire taxable income. Instead, they will pay 10% for $19,750, 12% for $60,500 and 22% for the remaining $44,950. Therefore, the total tax liability here will be $1,975 + $7,260 + $9,889, which equals $19,124.
We can conclude from this example, that if the trader files his or her trading earnings under section 988, then the effective capital gains tax rate would range from 0% to 37%. On the one hand, if a trader's only source of income is Forex trading and his or her annual earnings are at $12,400 or lower, then the market participant does not have to pay income tax.
On the other hand, for those traders whose other sources of income exceed $518,400, the effective capital gains tax will be 37%. It goes without saying that the majority of Forex traders will fall somewhere between these two extremes.
Reducing Taxable Income with Forex Losses
One major benefit for traders to file their trading earnings under section 988 is the fact that they can use the total amount of their net losses to reduce their taxable income. To understand this better, let us take a look at this 1-hour USD/JPY chart:
Let us suppose that the trader opens a long USD/JPY position at 107.14 level, by investing $10,000 at 1:10 leverage just like in our previous example. As we can see from the above diagram, the pair mostly move sideways, before dropping significantly by the end of July 2020.
Now, let us further suppose that faced with this downward trend, the market participant decides to cut his or her losses and liquidate the position at 105.12 level. This means that at the time of its closing, the market value of this trade was $98,114. As in the previous case, the brokerage company will take back its $90,000 loan and the trader is left with the remaining $8,114. Considering the fact that the market participant originally invested $10,000, the loss for this trade will amount to $1,886.
Now, let us return to our example of the couple with a $150,000 annual income. If they suffer this loss in trading, they can file their trading returns under section 988 and reduce their taxable income by $1,886. This means that instead of $125,200, their taxable income will be $123,314. Since they are in the 22% tax bracket, this will save them $414.92.
Forex Trading Tax Laws with Section 1256
Any proper Forex tax manual would mention that traders do have an alternative to file their earnings under section 988. In fact, they can decide to file their annual amount of gains or losses under section 1256.
In this case, 60% of traders’ annual earnings will be taxed at a fixed rate of 15%, while the other 40% will be taxed at the rate of the taxpayer's tax bracket, which can range from 10% to 37%. This can be an attractive option for those traders with a 22% tax bracket or higher.
To illustrate this better, let us return to our earlier example, of the couple with $150,000 annual income. Let us suppose here that $30,000 out of $150,000 came in from the Forex trading. Therefore, if the couple decides to file those earnings under section 988, then the effective capital gains tax will be 22%. Therefore, the total amount which should be paid in taxes will be $30,000 x 0.22, which is $6,600.
On the other hand, if they decide to file their trading earnings under section 1256, in this case, 60% of the amount, which is $18,000 out of $30,000, will be taxed at 15% and the remaining $12,000 will be taxed at 22%. Therefore, the total amount of tax will be $2,700 + $2,640, which is $5,340. So in this case the couple will be able to save $1,260.
As we can see from this example, many traders can save a considerable amount of money on tax by filing their trading earnings under section 1256. However, it does have one important downside. The total amount of losses that can be claimed under this section is capped at $3,000 per year. This means that if a trader suffers a net loss of $10,000 per year, then an individual will only be able to reduce his or her taxable income by $3,000.
Consequently, the choice between section 988 and 1256 will depend on the traders’ average earnings, as well as their tax brackets. For those market participants who often end up with net losses or are in the 10% or 12% brackets, filing under section 988 might be a better option.
On the other hand, for those traders who earn payouts consistently and are in the 22% tax bracket or higher, filing under section 1256 might be a worthy choice. So this choice entirely depends on one’s individual circumstances.
Paying Tax on Forex Trading Outside US
It goes without saying that every country’s tax code has its own approach for taxing payouts earned by Forex trading. In the United Kingdom, the tax-free allowance for capital gains stands at £12,300 in 2020. This means that if the total annual amount of capital gains is at £12,300 or lower, one does not have to pay any taxes in this category.
For anything above this amount, the tax rate can range from 10% to 20%, depending on the total annual income of the taxpayer. Considering that the first £12,300 gained is free from any taxation, the maximum effective capital gains tax for traders will usually be less than 20%.
One thing which makes the United Kingdom an attractive place for traders is the fact that the income earned from spread betting platforms is free of any capital gains tax. Nowadays, many brokerage companies in the UK offer their clients the ability to trade Forex on spread betting platforms. This seems beneficial for traders since they do not have to pay any taxes on those types of earnings.
In Switzerland, there is no capital gains tax. However, the fact of the matter is that those individuals considered to be ‘professional traders’ have to pay the same percentage of taxes as self-employed individuals.
However, traders can avoid this by holding on to each security for 6 months or more, or maintain a low trading volume, with sale proceeds making up less than 500% of the capital. Finally, those traders whose realized capital gains are less than 50% of their annual income can also avoid the ‘professional trader’ status.
In Canada, traders pay the same rate as their income tax on 50% of their total capital gains. However, this tax cut mostly applies to part-time traders. These full-time professional traders whose primary income comes from capital gains, have to pay the income tax rates for the entire annual earnings.