Trading Futures & Other Section 1256 Contracts Has Tax Advantages

There are various types of financial products with different tax treatments, and Section 1256 contracts have the best overall tax advantages.

Tax treatment of financial products affects investors, traders, and hedge funds. But sadly, many tax preparers overlook essential differences in tax treatment for these groups, resulting in overpayments. Education is key.

It’s important to distinguish between securities vs. Section 1256 contracts with lower 60/40 capital gains rates vs. other types of financial products like forex or swaps with ordinary income or loss treatment. Plus, there are various elections available to change tax treatment.

Capital gains vs. ordinary income

Most financial instruments — including securities, Section 1256 contracts, options, ETFs, ETNs, indexes, precious metals, and cryptocurrencies held as a capital asset — are subject to capital gains treatment. However, some of these financial products qualify as Section 1256 contracts with lower 60/40 capital gains rates.

By default, forex contracts and swap contracts are subject to ordinary gain or loss treatment. The distinction between ordinary and capital gains treatment makes a big difference. The capital-loss limitation is a problem for traders and investors who may have trouble using up large capital-loss carryovers in subsequent tax years. There is a Section 1256 loss carryback election.

Traders with trader tax status (TTS) and a Section 475 MTM election have business ordinary-loss treatment, which is more likely to generate tax savings or refunds faster than capital loss carryovers.

60/40 capital gains rates

Section 1256 contracts have lower 60/40 tax rates, meaning 60% (including day trades) are taxed at the lower long-term capital gains rate, and 40% are taxed at the short-term rate, which is the ordinary tax rate.

At the maximum tax brackets for 2018 and 2019, the top Section 1256 contract tax rate is 26.8% —10.2% lower than the highest ordinary rate of 37%. Section 1256 tax rates are 4.2% to 12% lower vs. ordinary rates depending on which tax bracket applies.

For example: Make $100,000 in 1256 contracts in the 35% ordinary bracket, and save $12,000 (12%) with 60/40 rates.

For 2018 and 2019, there is meaningful tax rate reduction throughout the brackets, including zero long-term rates in the 10% and 12% ordinary brackets.

See Section 1256 tax rates vs. ordinary rates (2018 & 2019 rates). State tax rates apply; they do not include a long-term rate.

Trading income is not self-employment income (SEI) for triggering SE tax (FICA and Medicare). Traders who are full members of a futures or options exchange are an exception here; they have self-employment income under Section 1402(i) on their exchange-generated trading gains reported on Form 6781.

List of 1256 contracts

U.S. futures contracts:

– Regulated futures contracts (RFCs) on a qualified board or exchange (QBE).

– U.S. RFCs on commodities (food, energies, and metals), stock indexes, financials (U.S. Treasuries and bonds), currencies, and more.

– Options on U.S. futures (RFCs).

– Foreign futures with CFTC and IRS approval. (Only a handful of exchanges currently have this IRS revenue ruling, including Eurex, LIFFE, ICE Futures Europe, and ICE Futures Canada, see blog post).

Broad-based indexes:

– Broad-based indexes are stock index futures made up of 10 or more underlying securities.

– Options on broad-based indexes are also 1256 contracts.

– Broad-based indexes are taxed differently from exchange-traded funds (ETFs), which are securities.

– The S&P 500 Index (CBOE: SPX) is listed on a commodities exchange, taxed as a Section 1256 contract.

– The SPDR S&P 500 ETF Trust (NYSEARCA: SPY) is listed on a securities exchange, taxed as a security.

Other Section 1256 contracts:

– Options on commodities/futures ETFs taxed as publicly traded partnerships. (Options on securities ETFs are securities.)

– CBOE-listed options on volatility ETNs structured as prepaid forward contracts (the ETN itself is not Section 1256).

– Non-equity options. (Be careful in using this catchall.)

– Forex forward contracts on major currencies, if the taxpayer filed a Section 988 opt-out election to use Section 1256(g) (we make a case for forex spot in major currencies, too).

– Forex OTC options (Wright tax court case).

Mark-to-market accounting

Section 1256 contracts use mark-to-market (MTM) accounting daily. For income tax purposes, MTM means gain/loss calculations report both realized activity from throughout the year, and unrealized gains and losses on open trading positions at year-end. The broker 1099-B also reverses unrealized amounts from the prior year.

With MTM, wash sale (WS) loss adjustments are a moot point; hence, WS apply to securities, only, not 1256 contracts.With MTM, traders don’t have to do “tax loss selling” at year-end, since they will report the unrealized losses, anyway. Many traders have small or no open positions on Section 1256 contracts at year-end.

It might be hard to find an accurate MTM price for valuing long-term options (1256 contracts) at year-end. The broker might use one price on the December monthly statement and a significantly different value on the 1099-B for calculating unrealized gains and losses. Brokers use Options Clearing Corporation (OCC) for FMV, which might be from the last trade in the marketplace. That trade might not indicate the actual FMV.Some taxpayers use Black-Scholes modeling to determine a more accurate FMV.

Tax reporting

With Section 1256 MTM and summary reporting, brokers can issue simple one-page 1099-Bs reporting “aggregate profit or loss on contracts” after taking into account realized and unrealized gains and losses.

That amount is reported on Form 6781 Part I, which breaks it down to the 60/40 split and then moves those amounts to Schedule D capital gains and losses. See a 2019 Form 1099-B lines 8 – 11 for 1256 contract reporting.

One might expect that broker-issued 1099-Bs would handle all tax treatment issues, but for some financial products, they do not. Some brokers categorize CBOE-listed options on volatility ETNs, and ETFs structured as publicly traded partnerships as securities, but there is substantial authority to treat these CBOE-listed options as “non-equity options” included in Section 1256. (Options on securities ETFs are taxed as securities.)The most complicated issue for 1099-Bs is wash sale loss adjustments on securities.

Section 1256 traders should also learn about the “mixed straddle election” and “hedging rules” in Section 1256(d) and (e), and as discussed on Form 6781. Offsetting positions between Section 1256 contracts and securities can generate tax complications under certain circumstances involving the hedging rule. The IRS is concerned about traders reporting Section 1256 MTM unrealized losses and deferring unrealized gains on offsetting securities positions, so there are rules intended to prevent this.

Election to carryback Section 1256 losses

On Form 6781, select the “net section 1256 contracts loss election” in box D. Enter, but don’t deduct the loss on the current tax return. Remove the loss from Form 6781 on line 6. Apply the Section 1256 loss on amended tax return filings against Section 1256 gains only. (Form 1045 is preferable; otherwise, use Form 1040X.) It’s a three-year carryback, and unused amounts are then carried forward. It’s the only time traders can carryback a tax loss. TCJA repealed NOL carrybacks starting in 2018.

Section 475 election

Traders eligible for trader tax status (TTS) are entitled to file a timely election for Section 475 ordinary gain or loss treatment on securities and or commodities (including Section 1256 contracts). Generally, Section 475 is smart for securities traders, but not most 1256 contract traders. Ordinary losses are usually better than capital losses; however, ordinary income rates are worse than 60/40 capital gains rates.

TCJA introduced a new Section 199A “qualified business income” (QBI) deduction. Trading is a “specified service trade or business” (SSTB) subject to an income threshold, phase-in, and cap on the QBI deduction. QBI includes Section 475 ordinary income/loss, and trading business expenses. However, QBI excludes capital gains, 60/40 capital gains, portfolio income, and Section 988 and swap ordinary income. There is uncertainty about this QBI application to traders based on Section 864(b). It is better to use 60/40 capital gains rates.

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