It’s tax season. And there are some particular IRS rules regarding taxes and trading. We’re not tax accountants, but we want you to make smart choices about your taxes just like you make smart choices about your trades. This article will help you ask your accountant the right questions to make the process easier.
Trade options? Trade futures? Trade ETFs? Not sure what tax treatment they get or how to differentiate? And what does the IRS Section 1256 tax treatment 60/40 mean anyway?
Stocks, stock options, ETFs and ETF options are generally taxed as long-term or short-term trades. Long-term trades are ones you’ve held for over a year. Short-term trades are ones you’ve held for one year or less. The tax rate is different on long- and short-term trades. You can get the specifics on the rates from your tax advisor. But if you trade futures, futures options and broad-based index options (e.g. SPX options), you need to be aware of 1256 contracts, marked-to-market and the 60/40 rule.
IRS Publication 550 addresses 1256 contracts & the 60/40 rule: https://www.irs.gov/publications/p550/ch04.html#en_US_2015_publink100010326.
We summarize some of this info below for you:
1256 contracts are U.S. Futures, options on futures, and options on broad-based indices like SPX, NDX, RUT, DJX and VIX. That’s not an all-inclusive list. But the two points about 1256 contracts are the following:
1) They need to be marked-to-market if you hold them through the end of a tax year.
2) Their profit and loss is split 60% long-term and 40% short-term regardless of how long you’ve held the trade.
- If you hold a Section 1256 contract at the end of the tax year, it should be “marked-to-market” and a profit/loss calculated as if you closed it at the end of the year for fair market value. You didn’t really close it, but you would report its profit or loss as if you did using the fair market value of the future or option on the last business day of the year to calculate it. You would report that unrealized, marked-to-market gain or loss on your tax return. When you finally really do close the 1256 contract, you would also take into account that gain or loss you already reported to the IRS on your prior tax return so that you don’t double report. See the example below.
- For Section 1256 contracts, you get to treat 60% of your gain or loss as long-term (which has more favorable tax rates) & 40% of your gain or loss as short-term. This is an advantage of 1256 contracts, which lets you take 60% of the profit at the more favorable long-term tax rate even if you held that 1256 contract for a year or less.
- Below, we’ve quoted IRS Publication 550, which contains a good example of calculating your gain or loss and what that might look like.
- Example: “On June 17, 2014, you bought a regulated futures contract for $50,000. On December 31, 2014 (the last business day of your tax year), the fair market value of the contract was $57,000. You recognized a $7,000 gain on your 2014 tax return, treated as 60% long-term and 40% short-term capital gain. On February 3, 2015, you sold the contract for $56,000. Because you recognized a $7,000 gain on your 2014 return, you recognize a $1,000 loss ($57,000 − $56,000) on your 2015 tax return, treated as 60% long-term and 40% short-term capital loss.”
Remember: wash sales do not apply to Section 1256 contracts (because they are “marked-to-market”).
So, what type of symbols qualify as a 1256 contract more specifically?
· U.S. Futures & Options on Futures
Futures or options on futures contracts, meaning it is traded on a qualified board of exchange or domestic board of trade.
· Broad-Based Index Options
(Examples: SPX, DJX, NDX, RUT, VIX…)
Broad-based index means that the index is made up of ten or more underlying securities. (If you’re doing the math in your head on your tax savings of your index option trades vs. the other products you trade, keep in mind these products generally have exchange fees that get passed to you from your brokerage firm.)
· Non-Equity Options
What about Equity Options or ETF Options?
They do NOT get Section 1256 marked-to-market tax treatment. Instead they are treated like stock. Generally, the only time Equity Options or ETF Options are allowed to be marked-to-market for tax purposes is if you are considered a “trader” in the eyes of the IRS and have made a 475(f) election.
- Equity Options – Equity Options are treated like stock for tax purposes.
- ETF Options – ETF Options are also treated like stock for tax purposes. (Examples: SPY, DIA, QQQ, IWM…)
As a retail investor, now you know the different tax treatments for the various options you may be trading. With all the new reporting rules the IRS has come out with for brokerage firms, the brokerage firms reporting is much better and now often sorts a lot of this for you…so, you can spend more time trading! Now, back to the markets…!
For more information on taxes check out our other blogs where we answer trader questions, here and here! Plus, have a question on tax forms? Check out this article. And here Kristi Ross answer viewer questions in our new tax special!