What Is a Section 1256 Contract?
A Section 1256 Contract is a type of investment defined by the Internal Revenue Code (IRC) as a regulated futures contract, foreign currency contract, non-equity option, dealer equity option, or dealer securities futures contract. What makes a Section 1256 contract unique is that each contract held by a taxpayer at the end of the tax year is treated as if it was sold for its fair market value, and gains or losses are treated as either short-term or long-term capital gains.
- A Section 1256 contract specifies an investment made in a derivatives instrument whereby if the contract is held at year-end is treated as sold at fair market value at year-end.
- The implied profit or loss from the fictitious sale are treated as short- or long-term capital gains or losses.
- Section 1256 is used to prevent manipulation of derivatives contracts, or their use thereof, to avoid taxation.
How Section 1256 Contracts Work
Let's use an instructive example using options trading: A straddle is a strategy that involves holding contracts that offset the risk of loss from each other. For example, if a trader buys both a call option and a put option for the same investment asset at the same time, his investment is known as a straddle.
Section 1256 contracts prevent tax-motivated straddles that would defer income and convert short-term capital gains into long-term capital gains. More specific information about Section 1256 contracts can be found in Subtitle A (Income Taxes), Chapter 1 (Normal Taxes and Surtaxes), Subchapter P (Capital Gains and Losses), Part IV (Special Rules for Determining Capital Gains and Losses) of the Internal Revenue Code (IRC).
The Internal Revenue Service (IRS) is responsible for implementing the IRC.
Traders that trade futures, futures options and broad-based index options need to be aware of Section 1256 contracts. These contracts, as defined above, must be marked-to-market if held through the end of the tax year. A profit or loss on the fair market value of the contracts should be calculated regardless of whether they were actually sold for a capital gain or loss. The mark-to-market profit/loss is actually unrealized but must be reported on the trader’s tax return. After the position is closed out in actuality for a realized gain/loss, the amount already reported on a prior tax return is factored in to avoid redundant report.
Wash sales do not apply to Section 1256 contracts because they are marked-to-market.
Investors reports gains and losses for Section 1256 Contract investments by using Form 6781, but hedging transactions are treated differently. Since these contracts are considered to be sold every year, the holding period of the underlying asset does not determine whether or not the gain or loss is short term or long term, rather all gains and losses on these contracts are considered to be 60% long term and 40% short term. In other words, Section 1256 contracts allows an investor or trader take 60% of the profit at the more favorable long-term tax rate even if the contract was only held for a year or less.
For example, assume a trader bought a regulated futures contract on May 5, 2017 for $25,000. At the end of the tax year, December 31, he still has the contract in his portfolio and it is valued at $29,000. His mark-to-market profit is $4,000 and he reports this on Form 6781, treated as 60% long-term and 40% short-term capital gain. On January 30, 2018, he sells his long position for $28,000. Since he has already recognized a $4,000 gain on his 2017 tax return, he will record a $1,000 loss (calculated as $28,000 minus $29,000) on his 2018 tax return, treated as 60% long-term and 40% short-term capital loss.
Form 6781 has separate sections for straddles and Section 1256 Contracts, meaning that investors have to identify the specific type of investment used. Part I of the form requires Section 1256 investment gains and losses be reported at either the actual price the investment was sold for or the mark-to-market price established on December 31. Part II of the form requires the losses on the trader’s straddles be reported in Section A and gains calculated in Section B. Part III is provided for any unrecognized gains on positions held at the end of the tax year, but only has to be completed if a loss is recognized on a position.