Tax on Unrealized Currency Gains

Foreign Exchange Market

• The most basic foreign exchange transaction is the spot, where you immediately exchange one currency for another based on an established exchange rate. A forward contract is an agreement to exchange currency at an established rate at some point in the future. A future contract is a standardized forward that can be freely traded on exchanges. The final means of participating in the foreign exchange is through an option contract, where the person can exchange one currency for another at a set rate. Unlike a futures contract, a person who holds an option contract is not required to execute the contract at the end of the term. Except for the spot transaction, the results from currency contracts are not immediately known.
  
  

Taxing Currency Contracts

• Under the tax code, currency contracts are the exception to the traditional realization standard for taxation. All currency contracts are treated as if they are sold at the end of the year for its fair market value and any resulting gain is taxed. The taxpayer uses the underlying exchange rate of the currencies in question as of the last business day of the year as well as any prices quoted on the relevant exchanges for those contracts to determine the taxable gain. When the contracts are resolved, any gain or loss you claimed in the prior year will be used to determine your taxable amount in the current year. So, if you claimed a $100 gain in Year 1 and made $150 when the contract was executed, you will only have to pay tax on the last $50. Furthermore, 60 percent of any gain from a mark-to-market transaction will be treated as long-term capital gain or loss, with the remaining 40 percent being treated as short-term. These gains and transactions are reported on Internal Revenue Service Form 6781.
  
  

Hedging Exception

• If the contract you acquired is for hedging purposes, you do not have to report any gains or losses on the foreign exchange contract prior to its termination. Hedging is the act of entering into a contract for the purpose of managing risk associated with depreciating or appreciating currency in conjunction with the taxpayer’s trade or business.
  
  

Tips and Disclaimer

• When completing your tax returns, consult with a certified public accountant to ensure that the returns are appropriately filed. While every effort has been taken to ensure this article’s completeness and accuracy, it is not intended to be legal advice.