The Tax Treatment of Contracts and Straddles

Investors and traders often use financial instruments subject to a unique set of tax regulations governing investment contracts and straddles. Unlike the straightforward buying and selling of stock, these positions are subject to special requirements that alter how and when gains and losses are reported. These rules deviate from standard capital gain and loss principles.

Defining a Tax Straddle

For tax purposes, a straddle is created when a taxpayer holds offsetting positions in personal property. This occurs when one position substantially diminishes the risk of loss from another, as the value of the two positions is expected to move in opposite directions. The term personal property includes commodities, currencies, and stock that is part of a straddle, such as when it is paired with an offsetting option.

A common example is buying shares of a company while simultaneously buying a put option on that same stock, as the put option offsets the potential loss on the shares. Another example involves shorting a stock and purchasing a call option on that stock. In this scenario, the call option protects the investor from losses if the stock price rises unexpectedly.

Taxation of Section 1256 Contracts

Certain financial instruments receive special tax treatment under IRC Section 1256. These contracts include regulated futures contracts, foreign currency contracts, non-equity options, and dealer equity options. The first governing principle is the mark-to-market rule, where every open contract is treated as if it were sold for its fair market value on the last business day of the tax year. This requires investors to recognize all unrealized gains and losses on these contracts annually.

The second rule is the 60/40 rule. All capital gains and losses on Section 1256 contracts are treated as 60% long-term and 40% short-term, regardless of how long the contract was held. Since long-term capital gains are taxed at lower rates, this treatment can result in a lower tax liability compared to gains from stock held for one year or less, which are taxed at ordinary income rates.

Taxation of Non-Section 1256 Straddles

Straddles not involving Section 1256 contracts, such as those with individual stocks and stock options, are governed by a loss deferral rule. This rule prevents taxpayers from realizing losses while deferring corresponding gains. A loss from closing one leg of a straddle can only be deducted to the extent that it exceeds the unrecognized gain in the offsetting position. Any suspended loss is carried forward and recognized when the offsetting gain is eventually realized.

For example, an investor buys 100 shares for $5,000 and a put option for $300. The stock later rises to $6,000 (a $1,000 unrecognized gain), and the worthless put is sold for a $300 loss. The investor cannot deduct the $300 loss because it does not exceed the $1,000 unrecognized gain on the stock; the loss is deferred until the stock is sold.

The straddle rules also affect the holding period of the assets. For a position held for less than one year when the straddle was established, its holding period does not begin until the straddle is terminated. This can prevent a gain from qualifying for long-term capital gains treatment.

Special Elections and Exceptions

Qualified Covered Calls (QCCs)

A covered call, which involves owning a stock and selling a call option on it, may be exempt from the straddle rules if it is a qualified covered call (QCC). To be qualified, the option must be traded on a national exchange, have more than 30 days to expiration when written, have a term of one year or less, and not be deep-in-the-money. If these conditions are met, the position is not treated as a straddle, and the loss deferral rules do not apply.

Identified Straddles

Taxpayers can designate a straddle as an identified straddle on their books on the day it is acquired. With this election, any loss on a position within the identified straddle is not recognized until all positions that are part of the straddle are disposed of. This election is irrevocable and must be clearly noted in the taxpayer’s records.

Mixed Straddles

A mixed straddle contains at least one Section 1256 contract and at least one non-Section 1256 position. To avoid complicated default tax treatment, taxpayers can make a mixed straddle election. This election allows them to choose a consistent taxation method, such as applying the mark-to-market and 60/40 rules to all positions or exempting the Section 1256 contracts and taxing the entire straddle under the loss deferral rules.

Reporting Gains and Losses on Form 6781

Taxpayers report gains and losses from Section 1256 contracts and straddles on Form 6781, Gains and Losses From Section 1256 Contracts and Straddles. This form organizes the transactions before the final numbers are transferred to Schedule D (Form 1040).

Part I is for reporting the aggregate profit or loss from all Section 1256 contracts, where the results of mark-to-market calculations are entered. The form then applies the 60/40 rule, splitting the net gain or loss into its long-term and short-term components for Schedule D.

Part II is used to report gains and losses from non-Section 1256 straddles. Section A of this part is where taxpayers calculate and report any loss being deferred to a future year because of unrecognized gains in offsetting positions.

Part III requires taxpayers to list the details of any positions with unrecognized gains held at the end of the tax year. This information substantiates the loss deferrals reported in Part II by showing the unrealized gains that prevent the deduction of corresponding losses.