What Is the 60/40 Method and How Does It Affect Taxes?

The 60/40 method is a tax rule found in Section 1256 of the U.S. Internal Revenue Code. It applies a blended tax rate to gains and losses from specific financial instruments. This rule allows investment gains and losses to be split, with 60% treated as long-term and 40% as short-term, regardless of the actual holding period. This can result in a lower effective tax rate compared to other short-term investments. For active traders, this consistent tax treatment simplifies planning and can be advantageous.

Qualifying Financial Instruments

The 60/40 rule applies exclusively to what the IRS designates as “Section 1256 contracts.” These are specific types of financial instruments that receive this unique tax treatment. The primary categories include:

• Regulated futures contracts. These are standardized agreements to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future, and they must be traded on or subject to the rules of a qualified board of exchange.
• Foreign currency contracts. These contracts, which involve the exchange of one currency for another at an agreed-upon rate on a future date, also fall under this rule if they are traded through a U.S.-approved exchange.
• Non-equity options. These are options whose underlying asset is not a single stock or a narrow-based stock index. A common example is an option on a broad-based stock index, which must be comprised of 10 or more underlying securities. Options on commodity ETFs and certain volatility exchange-traded notes (ETNs) can also qualify.
• Dealer equity options and dealer securities futures contracts. These are instruments held by dealers in the course of their business activities.

Tax Treatment and Calculation

A component of this tax treatment is the “mark-to-market” rule. Under this system, any open Section 1256 contracts held at the end of the tax year (December 31) must be treated as if they were sold for their fair market value on that day. This means taxpayers must recognize any unrealized, or “paper,” gains or losses for the year, even though the position has not actually been closed. This prevents the deferral of taxes on gains and accelerates the recognition of losses.

To illustrate, imagine a trader buys a regulated futures contract for $20,000. By December 31, the contract’s fair market value has risen to $25,000. Under the mark-to-market rule, the trader must recognize a $5,000 gain for that tax year, even though they still hold the contract. This $5,000 gain would then be subject to the 60/40 split, with $3,000 (60%) treated as a long-term capital gain and $2,000 (40%) as a short-term capital gain.

When the position is finally closed in the subsequent year, the gain or loss is calculated based on the difference between the final sale price and the marked-to-market price from the previous year-end. If the trader sells the contract for $28,000 in the next year, they would recognize an additional $3,000 gain ($28,000 sale price – $25,000 marked-to-market value). This $3,000 gain would also be allocated according to the 60/40 rule for that tax year.

Reporting on Tax Returns

Taxpayers must report all gains and losses from Section 1256 contracts on IRS Form 6781, Gains and Losses From Section 1256 Contracts and Straddles. In Part I of Form 6781, the taxpayer enters the aggregate net gain or loss from all Section 1256 contracts held during the year. The form is structured to automatically apply the 60/40 split to this total figure.

Once the calculations on Form 6781 are complete, the resulting long-term and short-term amounts are transferred to Schedule D (Capital Gains and Losses). The figures from Form 6781 are combined with other investment gains and losses to determine the final tax liability.

Special Loss Treatment

The tax rules for Section 1256 contracts provide a benefit when a taxpayer incurs a net loss for the year. If the result of all Section 1256 transactions is a net loss, an individual taxpayer can elect to carry that loss back to the three preceding tax years. Corporations, estates, and trusts are not eligible for this carryback. This provision allows traders to receive a potential tax refund by offsetting gains reported in prior years.

The carryback is subject to specific limitations. The net Section 1256 loss can only be used to offset prior-year Section 1256 gains. It cannot be used to reduce taxes paid on other forms of income, such as wages or ordinary investment income. When carried back, the loss retains its character, meaning it is still treated as 60% long-term and 40% short-term.

To utilize this provision, a taxpayer must make a formal election. This is typically done by filing an amended tax return for the prior year or years to which the loss is being carried. The taxpayer would recalculate the tax for the prior year, applying the loss against the gains, which would likely result in a refund of taxes previously paid.