If you trade futures, options, or similar investments, it’s important to familiarize yourself with Internal Revenue Code Sec. 1256. That section offers lower capital gains tax rates for shortterm trading of regulated futures contracts, foreign currency contracts, non-equity options (including broad-based stock index options), dealer equity options and dealer securities futures contracts (collectively, “Sec. 1256 contracts”) on a “qualified board or exchange” (QBE).
The 60/40 Tax Treatment
The primary tax benefit of Sec. 1256 contracts is lower capital gains tax. Generally, capital gains from other types of investments, such as stocks and stock options, are treated as short-term if they’re held for one year or less and as long-term if they’re held for more than one year. Short-term capital gains are taxed at rates as high as 43.4% (including the 3.8% net investment income (“NII”) tax). The top tax rate for long-term capital gains is 23.8% (including the NII tax). If you have a net capital loss from all trading, you can offset it against up to $3,000 of ordinary income. Excess losses may be carried forward indefinitely.
Gain or loss from a Sec.1256 contract is treated as 60% long-term and 40% short-term, regardless of the length of the holding period. Suppose, for example, that in 2015 Elizabeth makes $100,000 trading cattle futures on the Chicago Mercantile Exchange (CME). Assuming she’s in the top tax bracket, her capital gains tax is as follows: 60% of her gain is taxed at 23.8% ($60,000 x .238 = $14,280) and 40% of her gain is taxed at 43.4% ($40,000 x .434 = $17,360), for a total tax liability of $31,640. Had Elizabeth made the same amount trading stocks or stock options on a short-term basis, her tax liability would have been $43,400 ($100,000 x .434). In this example, Sec. 1256 effectively reduced her tax rate from 43.4% to 31.64%.
Sec. 1256 losses may be carried forward indefinitely. Unlike other capital losses, an election is available for Sec. 1256 transactions to carry the loss back up to three years to offset any Sec. 1256 gains.
Ordinarily, capital gains or losses aren’t recognized until an asset is sold or some other trigger event occurs. But if you hold any Sec. 1256 contracts at the end of a tax year, you must “mark them to market” — treat them as if they were sold for their year-end fair market value — and recognize any gain or loss.
When a Sec. 1256 contract is sold, any gain or loss is adjusted to reflect previous mark-to-market gains and losses.
Not all futures and options listed in Sec. 1256 automatically qualify for the capital gains tax treatment described above. They must also be traded on a QBE, and while most U.S. exchanges are QBEs, it can be more difficult for foreign exchanges to qualify. To avoid tax surprises, you should check to make sure a particular exchange meets IRS requirements.
In addition, only “broad-based” stock index options qualify as Sec. 1256 contracts. A broad-based index is one that falls outside the federal securities laws’ definition of a “narrow-based” securities index fund. Generally, an index is considered narrow-based if 1) it consists of nine or fewer stocks, 2) a component security comprises more than 30% of its weighting, or 3) the five highest weighted component securities in its portfolio in the aggregate comprise more than 60% of the index’s weighting. However, there are exceptions to these rules.
Determining whether a particular investment qualifies for Sec. 1256 treatment can be confusing, so it’s important to do your homework. It’s easy to make mistakes in determining whether an exchange is a QBE or a stock index is broadbased, so you can’t necessarily rely on information provided in Form 1099-B.
Contact your Untracht Early advisor if you need additional guidance on how to navigate Sec. 1256 treatment.