What Is the 60-40 Rule for Section 1256 Contracts?

The 60-40 rule is a specific tax treatment defined by Internal Revenue Code (IRC) Section 1256 for a particular class of financial instruments. This rule should not be confused with the common investment strategy known as a “60/40 portfolio,” which refers to an asset allocation of stocks and bonds. The tax rule provides a method for calculating capital gains and losses that can result in a lower blended tax rate by splitting the net gain or loss into two portions, each taxed at a different rate, regardless of the actual holding period.

Qualifying Section 1256 Contracts

Section 1256 contracts are traded on a qualified board or exchange, such as national securities exchanges registered with the SEC or domestic boards of trade designated by the Commodities Futures Trading Commission. The most common type of qualifying instrument is a regulated futures contract, which is an agreement to buy or sell a commodity or financial instrument at a predetermined price at a specified time in the future. Another major category is foreign currency contracts, which involve certain forward contracts on currencies for which futures also trade on regulated exchanges.

The rule also applies to non-equity options, which are options based on assets other than individual stocks, including broad-based stock indexes, commodities, or debt instruments. Contracts that do not fall into these categories, such as options on individual stocks, do not qualify for this tax treatment.

The Mark-to-Market System

The valuation of Section 1256 contracts is governed by a mark-to-market accounting system. Under this system, any open contracts held at the end of the tax year are treated as if they were sold for their fair market value on the last business day of that year. This means that both realized gains from closed positions and unrealized gains on open positions are recognized for tax purposes annually, which prevents the deferral of income.

For instance, if an investor buys a regulated futures contract for $20,000 and is still holding it on December 31, when its market value is $25,000, the investor must recognize a $5,000 gain for that tax year. This gain is reported even though the position remains open. If the contract is later sold for $27,000, the investor would only recognize the additional $2,000 gain in the year of the sale, as the initial $5,000 was already accounted for.

The total net gain or loss calculated through this process is then subject to the 60-40 rule. The wash sale rules, which can disallow losses on securities sold and repurchased within a short period, do not apply to Section 1256 contracts.

Calculating and Reporting Tax Consequences

The 60-40 rule dictates that 60% of the net gain or loss is treated as a long-term capital gain or loss, and the remaining 40% is treated as a short-term capital gain or loss. This allocation applies regardless of the actual holding period, meaning even a contract held for only a few days receives this split treatment.

The benefit of this split is that long-term capital gains are taxed at lower rates than short-term gains, which are taxed as ordinary income. By treating the majority of the gain as long-term, the rule creates a blended rate that is often more favorable than the rate that would apply to short-term trading profits from other types of assets. For example, at the highest income levels, this rate can be significantly lower than the top ordinary income tax rate.

Reporting these transactions requires using IRS Form 6781, Gains and Losses From Section 1256 Contracts and Straddles. Taxpayers aggregate all their gains and losses from these contracts on the form to arrive at a net figure. The resulting long-term and short-term figures from Form 6781 are then transferred to Schedule D (Form 1040), Capital Gains and Losses. The 60% long-term portion is combined with other long-term gains and losses, and the 40% short-term portion is combined with other short-term gains and losses.

Net Loss Carryback Election

If the net result from Section 1256 contracts for a year is a loss, an individual can elect to carry back the net loss to the three preceding tax years. This carryback is not available to corporations, estates, or trusts. The loss can only be used to offset net Section 1256 gains reported in those prior years and is applied to the earliest of the three years first. This process can result in a tax refund from a prior year, and any portion of the loss not used in the carryback period can be carried forward.

To make this election, a taxpayer must check Box D on Form 6781 for the year the loss occurred. The taxpayer would then file either an amended return (Form 1040-X) or Form 1045, Application for Tentative Refund, for the prior year(s) to which the loss is being applied. This filing must include an amended Form 6781 for each carryback year, showing the loss being applied against that year’s gains.