What Are IRC 1256 Contracts and How Are They Taxed?

Certain financial contracts are subject to a distinct tax rule for how gains and losses are calculated and reported each year, differing from the typical buy-and-hold standard. The regulations require an annual assessment of value, which can influence an investor’s tax obligations even on positions that have not been closed.

Identifying Section 1256 Contracts

Internal Revenue Code (IRC) Section 1256 governs the tax treatment of specific derivative contracts, known as Section 1256 contracts. Identifying whether an investment falls into one of the following classifications is the first step in applying the proper tax rules.

• Regulated futures contracts: These are agreements to buy or sell a commodity or financial instrument at a predetermined price on a future date and are traded on a regulated U.S. exchange.
• Foreign currency contracts: This includes certain forward contracts in currencies that are also traded through futures on regulated exchanges.
• Non-equity options: These are options contracts on any asset other than an individual stock, such as commodities, debt instruments, and broad-based stock indexes like the S&P 500 index.
• Dealer equity options and dealer securities futures contracts: These are specialized options and futures on stocks held by individuals or firms registered as dealers in these instruments.

While options on broad-based stock indexes are Section 1256 contracts, the treatment for options on exchange-traded funds (ETFs) that track these indexes is less certain. A distinction is that index options are cash-settled, while index ETF options are settled with fund shares. Because of this, there is no definitive guidance, and brokerage firms may report them differently.

The Mark-to-Market Tax Rule

Section 1256 contracts are subject to the mark-to-market rule, which mandates that any open contracts held at year-end be treated as if sold at their fair market value. This means investors must recognize any unrealized gains and losses for the year, even if they continue to hold the position. For example, if a futures contract bought in October increases in value by $5,000 by December 31, that $5,000 gain must be reported for that tax year. The value on December 31 then becomes the new cost basis for the contract to avoid future double-taxation.

A significant aspect of this tax treatment is the 60/40 rule. Regardless of the holding period, any capital gain or loss is treated as 60% long-term and 40% short-term. Long-term capital gains are taxed at lower rates than short-term gains, which can offer a tax benefit for short-term traders. Using the previous example, $3,000 (60%) of the $5,000 gain would be a long-term capital gain, and $2,000 (40%) would be a short-term capital gain.

Tax Reporting on Form 6781

Properly reporting gains and losses from Section 1256 contracts requires using IRS Form 6781, Gains and Losses From Section 1256 Contracts and Straddles. Before filling out the form, taxpayers must collect all necessary data. Brokerage firms that handle these investments typically provide a year-end Form 1099-B which summarizes this information.

The primary information needed is the aggregate profit or loss from all Section 1256 contracts for the tax year. This statement will show the total realized gains from contracts sold during the year, as well as the unrealized gains and losses on open positions calculated under the mark-to-market system.

Once the aggregate profit or loss is determined, it is entered in Part I of Form 6781. This part of the form is specifically for reporting the net gain or loss from all Section 1256 contracts and guides the taxpayer to apply the 60/40 split to this net figure.

After all calculations on Form 6781 are complete, the resulting gain or loss figures must be transferred to Schedule D (Form 1040). The short-term capital gain or loss is carried to the short-term section of Schedule D, and the long-term portion is carried to the long-term section. Attaching the completed Form 6781 to your tax return is the final step.

Special Elections and Exceptions

While the mark-to-market and 60/40 rules apply to most Section 1256 contracts, the tax code provides for exceptions. These provisions allow traders with complex strategies to opt out of the standard treatment. Two exceptions are for hedging transactions and mixed straddles.

A hedging transaction is an investment made to reduce the risk of price fluctuations in another asset. If a Section 1256 contract is part of an identified hedging transaction, its gains and losses are not subject to the mark-to-market or 60/40 rules. Instead, they are treated as ordinary gains and losses.

A mixed straddle involves holding offsetting positions that include both Section 1256 contracts and non-Section 1256 positions. For example, this could be holding a long stock position and a futures contract to sell that same stock. Taxpayers can make elections to coordinate the tax treatment of all positions within the straddle, avoiding potential timing and character mismatches.