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Why all the confusion?


Rabbi
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I can't believe there is so much confusion on this one issue. Hopefully, this answers the ordinary-income-vs-capital gain question once and for all. This following excerpt is verbatim from the Internal Revenue Code (italics and bold type added by me)

Sec. 1221. Capital asset defined

(a) In general

For purposes of this subtitle, the term ''capital asset'' means

property held by the taxpayer (whether or not connected with his

trade or business), but does not include -

(1) stock in trade of the taxpayer or other property of a kind

which would properly be included in the inventory of the taxpayer

if on hand at the close of the taxable year, or property held by

the taxpayer primarily for sale to customers in the ordinary

course of his trade or business;

(2) property, used in his trade or business, of a character

which is subject to the allowance for depreciation provided in

section 167, or real property used in his trade or business;

(3) a copyright, a literary, musical, or artistic composition,

a letter or memorandum, or similar property, held by -

(A) a taxpayer whose personal efforts created such property,

(B) in the case of a letter, memorandum, or similar property,

a taxpayer for whom such property was prepared or produced, or

© a taxpayer in whose hands the basis of such property is

determined, for purposes of determining gain from a sale or

exchange, in whole or part by reference to the basis of such

property in the hands of a taxpayer described in subparagraph

(A) or (B);

(4) accounts or notes receivable acquired in the ordinary

course of trade or business for services rendered or from the

sale of property described in paragraph (1);

(5) a publication of the United States Government (including

the Congressional Record) which is received from the United

States Government or any agency thereof, other than by purchase

at the price at which it is offered for sale to the public, and

which is held by -

(A) a taxpayer who so received such publication, or

(B) a taxpayer in whose hands the basis of such publication

is determined, for purposes of determining gain from a sale or

exchange, in whole or in part by reference to the basis of such

publication in the hands of a taxpayer described in

subparagraph (A);

(6) any commodities derivative financial instrument held by a

commodities derivatives dealer, unless -

(A) it is established to the satisfaction of the Secretary

that such instrument has no connection to the activities of

such dealer as a dealer, and

(B) such instrument is clearly identified in such dealer's

records as being described in subparagraph (A) before the close

of the day on which it was acquired, originated, or entered

into (or such other time as the Secretary may by regulations

prescribe);

(7) any hedging transaction which is clearly identified as such

before the close of the day on which it was acquired, originated,

or entered into (or such other time as the Secretary may by

regulations prescribe); or

(8) supplies of a type regularly used or consumed by the

taxpayer in the ordinary course of a trade or business of the

taxpayer.

Foreign currency does not fall into ANY of the categories excluded from the definiton of capital asset, therefore it IS a capital asset for those who are not in the business of buying and selling foreign currency.

Furthermore, Section 988 does not apply to us casual investors in foreign currency. Section 988 give ordinary income teatment to foreign currency transactions that relate to "Section 988 transactions." Once again, directly from the Internal Revenue Code, as follows:

Sec 988. Treatment of certain foreign currency transactions

(a) General rule

Notwithstanding any other provision of this chapter -

(1) Treatment as ordinary income or loss

(A) In general

Except as otherwise provided in this section, any foreign

currency gain or loss attributable to a section 988 transaction shall be computed separately and treated as ordinary income or loss (as the case may be).

© Other definitions

For purposes of this section -

(1) Section 988 transaction

(A) In general

The term ''section 988 transaction'' means any transaction

described in subparagraph (B) if the amount which the taxpayer

is entitled to receive (or is required to pay) by reason of

such transaction -

(i) is denominated in terms of a nonfunctional currency, or

(ii) is determined by reference to the value of 1 or more

nonfunctional currencies.

(B) Description of transactions

For purposes of subparagraph (A), the following transactions

are described in this subparagraph:

(i) The acquisition of a debt instrument or becoming the

obligor under a debt instrument.

(ii) Accruing (or otherwise taking into account) for

purposes of this subtitle any item of expense or gross income

or receipts which is to be paid or received after the date on

which so accrued or taken into account.

(iii) Entering into or acquiring any forward contract,

futures contract, option, or similar financial instrument.

Buying foreign currency as an investment, which is what most of us have undoubtedly done here, does not fall into any of the types of transactions that are considered "Section 988 transactions." I don't see how Section 988 is applicable here.

Edited by Rabbi
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I can't believe there is so much confusion on this one issue. Hopefully, this answers the ordinary-income-vs-capital gain question once and for all. This following excerpt is verbatim from the Internal Revenue Code (italics and bold type added by me)

Foreign currency does not fall into ANY of the categories excluded from the definiton of capital asset, therefore it IS a capital asset for those who are not in the business of buying and selling foreign currency.

Buying foreign currency as an investment, which is what most of us have undoubtedly done here, does not fall into any of the types of transactions that are considered "Section 988 transactions." I don't see how Section 988 is applicable here.

I, for one, have always agreed with what you say above even though ExecConsult makes a very good case for "ordinary income".

However, the most important part is that it doesn't matter what WE think or know or even what's right or fair or equitable.

The only thing that will matter is what the IRS thinks.

So everyone, all together now,

Please consult with your tax professional!!!

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Bahtman, I am a tax professional.

Wgb52, thanks for proving my point. If you were treating these transactions incorrectly for 10 years, certainly you would have here from IRS if they had a problem with it.

Rabbi,

Question for you. Is there a cap on long term capital gains past which the rate rises? What is that cap and what does the rate increase to?

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I have been trading currencies for over 10 years and have always claimed capital gains (and losses) when doing taxes.

Doing something for a number of years doesnt meant that it will pass the next year.

IRS can, more so if its a large gain, say that uit should be income taxed and when you show them all the previous years

then say its all good we will reverse all these years also and charge you accordingly with interest and penalty.

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  • 4 weeks later...

Haven't been on in a while so I am making lots of comments this morning. I hope what I say is not offensive to anyone. Just because I disagree with you does not mean in any way that I am attacking you personally. It just means that I disagree with you and I'd like to have the other side of the coin displayed for people to see. I, of course, welcome any response and discourse on the subjects.

I, for one, have always agreed with what you say above even though ExecConsult makes a very good case for "ordinary income".

However, the most important part is that it doesn't matter what WE think or know or even what's right or fair or equitable.

The only thing that will matter is what the IRS thinks.

So everyone, all together now,

Please consult with your tax professional!!!

Thank you bahtman for saying that I make a good case. :) That is kind of you. You make a good point that it only matters what the IRS will say in regards to this. That is why I think that the corroboration I got from the IRS is so important. Not what some telephone help desk told me or some email answer person, but someone who knows what they are talking about and deals in the area. I sent my analysis to a friend in the IRS who is a criminal investigator and she got it to an International Examiner. The international examiner agrees with my analysis.

I have been trading currencies for over 10 years and have always claimed capital gains (and losses) when doing taxes.

Trading currencies is not the same as holding physical currency. If you have been holding and exchanging physical currency for 10 years and always claiming capital gains, it is good that you have not been audited in that time.

If you are trading through forex, you have currency contracts. Those should either receive ordinary income treatment under section 988 or (if you opt out of 988 to 1256) capital gains treatment under section 1256.

If you are holding physical foreign currency, 1256 can not be applied and you are stuck under section 988(e). That is the difference here - you are holding foreign currency - not contracts.

Bahtman, I am a tax professional.

While "tax professional" could mean a lot of different things, I am going to assume that you deal with taxes at a professional level. That makes me happy because we should be able to have a good conversation back an forth.

Foreign Currency is "cash" as defined in revenue ruling 69-63 (unless it has numismatic value like a coin collection). It really doesn't matter what asset class you want to place cash in. We must find the law that controls it.

I can see your point about section 988. However, if you go a little further you will find "Special rules for disposition of nonfunctional currency." As I am sure you understand, in legal construction, when you have a general rule and then a specific rule, the specific rule trumps. The specific rule would be section 988( c) (1) ( c) which states:

( C) Special rules for disposition of nonfunctional currency

(i) In general In the case of any disposition of any nonfunctional currency—

(I) such disposition shall be treated as a section 988 transaction, and

(II) any gain or loss from such transaction shall be treated as foreign currency gain or loss (as the case may be).

(ii) Nonfunctional currency For purposes of this section, the term “nonfunctional currency” includes coin or currency, and nonfunctional currency denominated demand or time deposits or similar instruments issued by a bank or other financial institution.

You will understand of course that non-functional currency for us in the US is anything that is not USD (the bills and coin we use in our day to day activities in the US). I am also sure that, as a tax professional, you can easily look up the regulations supporting the code which give examples of disposition of foreign currency being as simple as paying for a night at a hotel (example for 988(e)(2)).

Section 988 controls gains and losses realized due to disposition (spending, exchanging, or trade/barter) of any nonfunctional (foreign) currency. Since section 988 controls, my thoughts are still that you have ordinary income.

If you want to look further into what my analysis is, you can look here:

Best of Blessings,

Mark

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Mark,

Why do you consider the NID "non-functional" currency?

It functions just fine inside of Iraq, and is accepted as legal tender in a number of other areas.

Semper Fidelis

Non-functional currency is decided by definition. It is basically anything that is not the functional currency of the country you are in. Functional currency is defined a little differently by different groups, but they all are similar. The best one that I found follows:

Currency of the country (called the 'primary environment' ) in which a firm a conducts its business activities and generates most or all of its income and expenses. It may or may not be the currency in which it presents its financial statements, which is called reporting currency or presentation currency. For U.S. firms operating in foreign countries, the reporting requirements are governed by the rules of the Financial Accounting Standards Board, particularly statements 8 and 52 (FASB No. 8 and FASB No. 52).

Read more: http://www.investorwords.com/7319/functional_currency.html#ixzz1FMfKrFw3

(If you are interested in really digging into this you can look at sections 985 and 989 of the internal revenue code which teaches a Qualified Business Unit (QBU)to determine which currency is their functional currency.) However, for us it is very simple. You are an individual. You are a US citizen. Your functional currency is US currency. ALL OTHER CURRENCIES ARE "non"functional currencies to you under the code. If you had a QBU operating in Iraq, it would be likely that the IQD would be the functional currency for that QBU.

Hope that helps.

Best of Blessings,

Mark

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  • 2 weeks later...

tax guys, i appreciate your efforts in explaining this to all of us regular joes. i read recently in a rumor, that section 525 and 988 have been reconsidered by the irs...this could be huge. 15% vs 35% paid to the govt. any input would be apprciated. I would tend to lean toward paying the 35% (regular income) vs the 15% capital gains. thanks, jr

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tax guys, i appreciate your efforts in explaining this to all of us regular joes. i read recently in a rumor, that section 525 and 988 have been reconsidered by the irs...this could be huge. 15% vs 35% paid to the govt. any input would be apprciated. I would tend to lean toward paying the 35% (regular income) vs the 15% capital gains. thanks, jr

Wish it were true, but I can't find anything to support the rumor except for a lot of people repeating the same rumor. I don't believe their is any basis in fact at this point.

Best of Blessings,

Mark

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