List of Qualifying Section 1256 Contracts
Not all derivatives receive the same tax treatment. Understand the key distinctions for contracts qualifying for the favorable 60/40 capital gains rule.
A Section 1256 contract is a specific type of investment defined by the Internal Revenue Code that receives distinct tax treatment. These financial instruments are traded on regulated exchanges and are subject to special rules that can provide a tax advantage compared to other types of investments. The purpose of this classification is to standardize tax reporting for certain actively traded contracts and prevent the deferral of short-term gains.
The 60/40 Rule and Mark-to-Market System
The tax treatment of Section 1256 contracts is governed by two main principles: the 60/40 rule and the mark-to-market system. The 60/40 rule dictates that any capital gain or loss on these contracts is treated as 60% long-term and 40% short-term, irrespective of the actual holding period. This is beneficial, as long-term capital gains are often taxed at lower rates.
To illustrate, if a trader realizes a $10,000 gain from a contract held for two months, $6,000 of that gain is taxed at the long-term capital gains rate, and $4,000 is subject to the higher short-term rate. Without this rule, the entire $10,000 would be a short-term gain taxed at the trader’s ordinary income rate.
The second component is the mark-to-market system, which requires that all open Section 1256 contracts be treated as if they were sold for their fair market value on the last business day of the tax year. This means both unrealized and realized gains and losses must be reported annually. This prevents the indefinite deferral of taxes on gains and allows for the recognition of losses sooner.
Qualifying Section 1256 Contracts
Several specific types of financial instruments fall under the Section 1256 classification. To qualify, these contracts must be traded on or subject to the rules of a “qualified board or exchange” as defined by the IRS. The most common categories are:
- Regulated futures contracts: These are standardized agreements to buy or sell a specific commodity or financial instrument at a predetermined price on a future date. This broad category includes contracts on market indexes like the S&P 500 e-minis, commodities such as crude oil and gold, and financial instruments like U.S. Treasury bonds.
- Foreign currency contracts: This category primarily includes foreign currency forward contracts for a currency in which positions are also traded through regulated futures. These are typically traded in the interbank market and include forwards on major currency pairs like the Euro/U.S. Dollar.
- Nonequity options: These are options whose value is derived from anything other than a single stock or a narrow-based stock index (one with fewer than ten securities). Common examples are cash-settled options on broad-based stock indexes like the S&P 500 Index (SPX), the Russell 2000 Index (RUT), and the CBOE Volatility Index (VIX).
- Dealer equity options and dealer securities futures contracts: These are specialized categories that apply to individuals or firms registered as dealers in these instruments. These classifications are not applicable to the average retail trader.
Contracts Excluded from Section 1256 Treatment
Understanding which contracts do not qualify for Section 1256 treatment is important, as misclassifying an investment can lead to incorrect tax reporting. The exclusions generally center on instruments tied to individual equities or funds treated like individual equities.
The most common exclusion is options on individual stocks. An option to buy or sell shares of a specific company, such as Apple (AAPL) or Tesla (TSLA), is not a Section 1256 contract. Gains and losses from these options are subject to standard capital gains rules, where the holding period determines the tax treatment.
Options on most exchange-traded funds (ETFs), which are organized as investment companies holding stocks, are taxed like options on individual stocks. For this reason, options on popular ETFs like the SPDR S&P 500 ETF (SPY) are excluded. This creates the important distinction where options on the S&P 500 Index (SPX) qualify, but options on the SPY ETF do not. However, options on certain exchange-traded products structured as trusts or partnerships can qualify.
Holding a physical commodity itself does not constitute a Section 1256 contract. For example, owning gold bullion is an investment in a collectible, and its sale is taxed accordingly. Only the regulated futures contract for gold, traded on a qualified exchange, falls under Section 1256.
Reporting on Tax Form 6781
All gains and losses from Section 1256 contracts are reported on IRS Form 6781, Gains and Losses From Section 1256 Contracts and Straddles. This form is the primary document for applying the mark-to-market rules and the 60/40 split. Taxpayers report an aggregate figure for the year rather than calculating the split for each individual trade.
The process begins with the information provided by a broker on Form 1099-B. Box 11 of this form shows the aggregate profit or loss for the year, which already includes both realized and mark-to-market figures. This total net gain or loss is entered in Part I of Form 6781.
Once entered, the form’s calculations automatically allocate 40% of the amount as a short-term capital gain or loss and 60% as a long-term capital gain or loss. These resulting figures are then transferred from Form 6781 to the appropriate lines on Schedule D, Capital Gains and Losses, where they are combined with other capital gains and losses for the year.