FUTURES & SECTION 1256 CONTRACTS

BENEFIT FROM THE OFTEN-PREFERRED TAX TREATMENT

FUTURES & SECTION 1256 CONTRACTS

BENEFIT FROM THE OFTEN-PREFERRED TAX TREATMENT

Futures trades typically qualify as IRS Section 1256 contracts with different capital gains tax treatment than ordinary options. Traders and active investors with Section 1256 contracts benefit from lower 60/40 capital gains tax rates, and simpler reporting.

CONTENTS

WHAT ARE FUTURES CONTRACTS?

Futures are a form of derivative contract for buying or selling a given asset at a fixed price on a future date (the expiration), no matter the market price on that date. The asset could be a specific commodity or a security. Futures contracts are standardized for trading on an exchange – such as the CME Group. You’ll need a brokerage account approved for trading futures.

Futures can be used for either hedging or speculating.

Hedging futures involves buying or selling with intentions to actually receive or deliver the underlying commodity. Companies or institutional investors may use futures in this way to help manage risk and prevent losses to their operations or investment portfolio.

Speculating futures is perhaps the most common use by individual traders and investors. Because futures can be bought and sold up to the time of expiration, traders can buy and sell future to profit from the direction of the market. The trader has no intention of owning the underlying asset, and so, before expiration, they will typically buy or sell an offsetting position to eliminate their obligations.

Types of Futures

Futures as a class can refer to a number of types of futures contracts available for trading, such as…

  • Commodity futures – like oil, corn, or wheat
  • Precious metal futures – like gold or silver
  • Index futures – like the S&P 500 or Russell 2000 
  • Currency futures – like on the Euro, Pound, or CME Bitcoin
  • U.S. Treasury Futures – like 2-year and 5-year T-Notes

Options on Futures

Traders can also take advantage of options on futures in order to diversify, hedge other positions, or perhaps trade in the futures markets at less cost.

Options on futures are typically much like equity options, allowing the holder rights to buy or sell a specific futures contract at a given strike price on or before the expiration date. Traders often use the same strategies as well. However, most options on futures are cash settled, and also tend to be European-style – meaning they cannot be exercised early.

How Futures are Taxed

Futures are typically taxed as Section 1256 contracts with marked-to-market treatment if held open at year end. 

IRS Publication 550:

A commodity futures contract is a standardized, exchange-traded contract for the sale or purchase of a fixed amount of a commodity at a future date for a fixed price.

If the contract is a regulated futures contract, the rules described earlier under Section 1256 Contracts Marked to Market apply to it.

The termination of a commodity futures contract generally results in capital gain or loss unless the contract is a hedging transaction.

WHAT IS A SECTION 1256 CONTRACT?

Here is what the IRS says in Publication 550:

A section 1256 contract is any:

  • Regulated futures contract,
  • Foreign currency contract,
  • Nonequity option,
  • Dealer equity option, or
  • Dealer securities futures contract.

Wondering what a nonequity option is?

Nonequity Option:

This is any listed option (defined later) that is not an equity option. Nonequity options include debt options, commodity futures options, currency options, and broad-based stock index options. A broad-based stock index is based on the value of a group of diversified stocks or securities (such as the Standard and Poor’s 500 index).

Nonequity options is sort of the catchall – with definite benefits for many traders. This category includes broad-based index options, as well as many ETF options for commodity, precious metal, and volatility ETFs. See ETF and Broad-Based Index Options

Benefits of Section 1256 Treatment

The good news for traders of Section 1256 contracts is twofold:

  1. 60% of the capital gain or loss from Section 1256 Contracts is deemed to be long-term capital gain or loss and 40% is deemed to be short-term capital gain or loss. What this means is a more favorable tax treatment of 60% of your gains.
  2. A special loss carry-back election is allowed. Section 1256 contract net losses can be carried back 3 years instead of being carried forward to the following year. These losses can only be carried back to a year in which there is a net Section 1256 contracts gain, and only to the extent of such gain, and cannot increase or produce a net operating loss for the year. The loss is carried back to the earliest carry-back year first and any unabsorbed loss can then be carried to each of the next two years.  So if you have a net loss for the year, you can amend a previous year’s tax return and possibly get a refund!

Section 1256 contracts are reported on IRS Form 6781. Part I, Line 2 of this form simply asks for your total gain or loss, and then it splits this loss as 40% short-term on Line 8 and 60% long-term on Line 9.  These entries then flow to your Schedule D – Part I, Line 4 for short-term capital gains and Part II, Line 11 for long-term capital gains.

No additional detail or complex matched trade report (as required for capital gains from stocks, options, etc.) is required.

Section 1256 Contracts are Marked-to-Market

Section 1256 contracts are marked-to-market, meaning any positions held open at year-end are marked as closed at fair-market value. The unrealized gain or loss is then reported in the tax year reporting. On January 1 of the following year, those positions are marked as open at the same year-end price.

Traders who elect Section 475 Trader Tax Status often make the election only for securities, allowing them to retain the preferred 60/40 capital gains tax rates on their Section 1256 contracts.

BENEFITS OF USING TRADELOG SOFTWARE

TradeLog imports futures trades from select brokers, handles necessary year-end mark to market adjustments and generates necessary totals for Form 6781 reporting. Although brokers often report the totals for futures trading on 1099-B, they may not identify and segregate broad-based index options or ETF options which should be reported with your futures trading.