Since this issue comes up quite often, I thought I'd cover it right off the bat. First, let me preface by saying I am not a tax or accounting professional, and I highly suggest that you consult one prior to following this or any other tax-related advice. I happen to know one of the best, however - Robert Green - and there's a link to his site below.

By default, speculative forex transactions are treated by the IRS as 1256 "contracts and straddles", and get the lower 60/40 treatment. What is 60/40? Normally, capital gains (investment income) are taxed at a lower rate if they are "long-term" investments (held over 1 year), and a higher rate if held under a year ("short-term capital gains"). Naturally, in Forex it is rather difficult to hold onto positions for over a year (unless you are a carry trader). Therefore your capital gains are automatically split 60/40 between the higher and lower rates.

There is another section of IRS tax code called IRC 988, or "foreign currency transactions" . Here amounts are treated as ordinary gains or losses. One reason someone may choose this option is if they have a lot of losses (rather than gains). But... be careful. The IRS is fairly strict on making elections - you cannot cherry pick after-the-fact. They can only be done on Jan 1st or the start of your trading year, and revoked only with IRS consent.

Usually, spot forex will fall under IRC 1256, but to be absolutely safe go ahead and make a formal election one way or another (since forex is still somewhat a "gray" area - depending on whether it is traded on a US or a foreign "exchange", and whether or not you trade it as "futures contract"). What is an "election"? It is a document you write, sign, & date which summarizes your intended accounting practices (also includes things like your fiscal year, etc.). At this time, the IRS does not require that you file a copy with them, only that you keep it on file (though this too may change).

Declarations under IRC 1256 are reported on IRS Form 6781, where they are split 60/40 prior to being transferred to Schedule D. Declarations under IRC 988 are only reported in summary form on Line 21 of Form 1040.

This is only a summary of the present laws (and tax laws frequently change), so I highly recommend that you visit Robert Green's very detailed site on the matter.