No matter how you perceive trading on the stock exchange – additional income, the main source of income or entertainment – in essence, this activity is related to finance. And this means that it is subject to taxes. Yes, yes, in this sense, trading is no different from buying or selling retail goods. However, it hides many nuances related to the nature of your trading, the amount of profit and the peculiarities of the legislation of the country of your residence and/or citizenship.

In this article, we explain the main points regarding taxation for traders.

Understanding fixed assets and trading assets

First of all, of course, the taxation features depend on the legislation of the country in which you live or of which you are a citizen. For example, regardless of your place of residence, you will automatically pay taxes to the country’s treasury when you buy food in a supermarket. On the other hand, if you have a US passport, you must report your taxes, even if you don’t currently live in the States.

Although the terms “trader” and “investor” are often interpreted as synonyms, the difference in their interpretation is extremely important for the nature of taxation. Investors and traders, although they operate in financial markets, have significant differences in their approaches to investing and, accordingly, in the taxation of income received.

An investor is a person who acquires securities with a long-term perspective. The goal of investing is to make a profit through the growth of the asset value (capital gain) and dividend payments. Income received from the sale of investment assets is subject to capital gains tax. The tax rate depends on how long the investor owned the securities: long-term or short-term.

A trader, on the other hand, is focused on short-term profits and often makes numerous purchase and sale transactions of securities over a short period of time. In this case, the trader’s income is considered income from entrepreneurial activity and is taxed on a general basis, like any other business income. The tax rate on such income can reach significant amounts and depends on the total amount of the trader’s income.

Thus, the key difference between an investor and a trader is the investment horizon and, as a result, the tax consequences. Investors typically benefit from more favorable tax treatments related to capital gains tax, while traders are taxed at the general rate, which can result in higher tax payments.

Taxation for day traders

Taxation of investments is generally subject to relatively simple rules. However, taxation of intraday trading is more complex and multifaceted.

A key point in determining tax liability is the classification of an asset: as a fixed asset or as a trading asset (commodity shares). The tax consequences for these two categories are significantly different.

The interpretation of a “fixed asset” depends on the specifics of the legislation of the country in which you live or of which you are a citizen. For example, fixed assets can include any property owned by a taxpayer, regardless of whether it is used in business activities. It is important to note that commodity shares and personal assets are generally not included in the concept of fixed assets, except for some specific cases.

The legal regulation of share ownership depends significantly on their classification. In tax law, shares can be classified either as fixed assets or as trading assets (commodity shares). Correctly determining the status of shares is extremely important, since the tax consequences of owning different types of shares vary significantly.

Basic taxes

Income tax. This is one of the main types of taxes that the state collects from individuals and legal entities for the income they receive. Essentially, it is a certain percentage of your salary, business profits or other sources of income that you pay to the state. The corresponding tax rate is applied to the received tax base. Rates can be progressive (the higher the income, the higher the rate) or fixed.

To illustrate this, let’s take the example of the UK, where the percentage rate is progressive. This means that the amount of tax depends on the amount of taxable income. So, if the taxpayer’s annual income exceeds the personal threshold, the following rates are applied to his income:

  • 20% – on the amount of income exceeding £12,570, but not exceeding £50,270;
  • 40% – on the amount of income exceeding £50,270, but not exceeding £125,140;
  • 45% – on the amount of income exceeding £125,140.

It is important to note that when determining the tax base, all types of income of an individual are summed up, including wages, income from entrepreneurial activity, income from investments, etc.

National insurance contributions. These are mandatory payments that you make from your earnings. They go into a special fund that is used to finance various social programs. The amount of contributions usually depends on your salary. The higher your income, the more you pay. There may also be various benefits and exceptions for certain categories of citizens.

Capital gains tax. This is a type of tax that is levied on the profit made from the sale of an asset that has increased in value over a period of time. In other words, it is a tax on the difference between the price at which you bought the asset and the price at which you sold it.

Under current UK tax law, individuals who carry out trading activities and make a profit from the sale of assets are subject to Capital Gains Tax (CGT). The threshold for triggering the tax liability in the 2024/2025 tax year is £3,000. This means that if the amount of profit made from the sale of assets exceeds this amount, the taxpayer is liable to pay capital gains tax.

It should be noted that the tax liability for CGT arises regardless of the status of the taxpayer – whether self-employed, part-time or full-time. The criterion for the application of the tax is solely the excess of the threshold value of profit from the sale of assets.

Tax nuances on Forex and futures

Forex options and futures contracts are, for US tax purposes, contracts defined in Section 1256 of the Internal Revenue Code. These contracts are subject to a special 60/40 tax regime. This means that 60% of the gain or loss from these transactions is classified as long-term capital, and the remaining 40% is classified as short-term capital. This approach often proves advantageous for investors with high incomes.

In comparison, gains from the sale of stocks that were purchased less than a year ago are always considered short-term capital and are taxed at the rate applicable to ordinary income, which can be as high as 37%. At the same time, when trading futures or options, an investor, thanks to the 60/40 regime, is effectively taxed at the maximum long-term capital gains rate (20% on 60% of the gain) and the maximum short-term capital gains rate (37% on the remaining 40%).

According to US law, fixed assets include all types of property owned by a taxpayer, regardless of its connection with his professional activity. However, commodity stocks and personal assets, with some exceptions, are not included in this category.

Depending on the classification of stocks and the period of ownership, income from their sale may be classified as follows:

  • Long-term capital gain (LTCG) and loss: arises from the sale of stocks classified as capital assets and held for more than a certain period.
  • Short-term capital gain (STCG) and loss: arises from the sale of stocks classified as capital assets and held for less than a certain period.

Income from day trading may be classified as speculative business income. This classification is due to the speculative nature of day trading, the purpose of which is to make a profit from short-term fluctuations in market prices.

All income from day trading is included in the total taxable income of an individual and is taxed at the appropriate rate established for this taxpayer. In other words, profits from day trading are added to other income of the taxpayer (e.g., wages, dividends) and income tax is calculated on the total amount.

Do US traders have tax choices?

One of the most complex issues in taxing income from trading options, futures, and OTC instruments is the choice between two tax regimes: IRC 1256 and 988 contracts. Although these instruments are often considered together, an investor has the right to independently determine which scheme to use for paying taxes. Moreover, this decision is made at the beginning of each calendar year and is quite difficult to change later.

IRC 988 contracts are generally considered easier to use. They imply a single tax rate for both profits and losses, which is especially beneficial if the trader records a net loss at the end of the year. IRC 1256 contracts, although having a more complex tax structure, can be more beneficial for traders receiving a net profit, since they allow for streamlining tax payments.

Generally, accounting firms recommend using 988 contracts for spot traders and 1256 contracts for those who primarily trade futures. However, the final decision is always up to the investor and depends on their individual circumstances. It is important to consult with a qualified professional before commencing trading, as the chosen tax regime will be in effect for the entire year and will be difficult to change later.

Additional complications arise for investors who trade both stocks and forex pairs. The differences in tax treatment of these instruments can make choosing between 988 and 1256 contracts very difficult, requiring careful analysis and an individual approach.

Taxes for over-the-counter (OTC) Forex traders

U.S. spot currency traders are generally covered by Section 988 of the Internal Revenue Code. This section is specifically designed for currency transactions that are executed within two business days. The short-term nature of the transactions means that gains and losses from them are generally treated as ordinary income and expenses. Consequently, traders who actively trade spot currency are often referred to as “988 traders.”

This status is especially beneficial if the trader has a net loss from currency transactions at the end of the year. Unlike other categories of taxpayers, “988 traders” can take into account all of their currency losses in full when determining their taxable base. This is a significant difference from the general rules, according to which capital losses can only be offset up to a certain limit (for example, $3,000 per year).

Forex tax record keeping

Although brokerage reports provide some information about your trading activity, it is recommended that you keep your own records to more accurately record your profits and losses. This approach won’t only provide a detailed picture of your trading results, but will also simplify the process of preparing your tax return.

There are several methods for recording trading activity, but one of the most common and effective is the method based on comparing the initial and final capital. To do this, you need to subtract the initial account balance from the final balance, taking into account all intermediate transactions such as deposits and withdrawals, accrued and paid interest, and other expenses related to trading.

Using this method will provide a more accurate picture of the financial results of your activity, determine the ratio of profit and loss, and also facilitate the process of preparing tax returns. In addition, detailed trading activity records will allow you to analyze the effectiveness of various trading strategies and make more informed decisions in the future.

What else is important to consider regarding taxation in the Forex market?

Taxation of income received from trading on the Forex currency market has its own peculiarities. In order to avoid problems with tax authorities, it is recommended to adhere to the following principles.

Firstly, it is extremely important to decide on the tax regime that will apply to your trading operations in a timely manner. As a rule, such a choice must be made before the beginning of the calendar year. However, if you are a novice trader, you can make the appropriate decision before making your first transaction.

Secondly, keeping detailed records of all trading operations is a prerequisite for proper taxation. Systematic accounting will save time and nerves when preparing a tax return, as well as minimize the risk of errors.

Finally, it is important to remember that tax evasion on Forex trading income is illegal. Even though many currency transactions are conducted off-exchange and are not regulated by bodies such as the Commodity Futures Trading Commission (CFTC), tax authorities have all the necessary tools to identify and prosecute tax violators. Penalties for tax evasion can significantly exceed the amount of the tax itself.

Thus, tax compliance is an integral part of successful trading in the forex market.