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Futures, Non-Equity and Stock Index Options – Be Aware of the Special "Mark-to-Market" Tax Rules
Investors should not live on bread alone, and so it is not surprising that for many investors their investment portfolio also includes the purchase of futures contracts, as well as exchange listed non-equity options and stock index options.  But these investments trigger a number of potentially unexpected tax consequences that you should consider.


If you hold a contract or option subject to the Section 1256 mark-to-market rules, you might be surprised come tax-time because you will be taxed on such items based on their value at year-end, rather than waiting until they are sold or disposed.  And special rules apply to determine the amount of capital gains and losses that are long-term and short-term.

An investor is generally taxed on such contracts and options (and certain foreign currency contracts) under a special set of "mark-to-market" rules pursuant to Internal Revenue Code Section 1256, rather than under basic federal income tax principles that focus on the disposition or sale of investments as triggering "recognized" gain or loss.  Under the Section 1256 mark-to-market rules, you generally treat contracts and options subject to the rules as sold at fair market value at the end of your tax year for purposes of computing taxable gains and losses.   You must also include gains or losses from such contracts and options disposed of during the year, and take into account the prior year's marking to market in determining gains and losses.  IRS Publication No. 550 on "Investment Income and Expenses" (available from the IRS at ) includes a section in Chapter 4 regarding Section 1256 contracts.  Note that there is a different set of mark-to-market rules under Code Sec. 475 that apply to dealers in securities (and electing dealers in commodities and traders)—the Sec. 475 rules are not discussed here.

In addition, different tax return reporting rules apply to Section 1256 contracts.  Gains and losses from such contracts are reported on IRS Form 6781, titled "Gains and Losses from Section 1256 Contracts and Straddles" and the net amounts from that form are then included on Schedule D.  GainsKeeper includes tools to assist Section 1256 mark-to-market reporting.

And there's more.

A taxpayer must determine whether capital gains and losses are long-term or short-term.  Long-term capital gains are taxed at favorable tax rates.  Because short-term gains are taxed at regular tax rates, short-term capital losses that can offset short-term gains can be more valuable than long-term losses in certain cases (caution: this is an oversimplification given the complexities associated with capital gains and losses).  Ordinarily, you look to the holding period of the investment disposed to determine whether gains or losses are long-term or short-term.  If the investment has been considered held by the taxpayer for more than one year (under the Code rules for determining holding period), gain or loss is generally long-term.  If held for one year or less, it is generally short-term.

The normal long-term/short-term holding period rules do not apply to contracts and options subject to the Section 1256 mark-to-market rules.  Instead, an arbitrary "60/40" rule applies and 60% of the gains/losses are treated as long-term and 40% are treated as short-term, regardless of the actual holding period of the contract or option.  Investors should compare the differing tax rules that generally apply to investments and the mark-to-market rules applicable to Section 1256 contracts to determine which type of investments may offer certain tax advantages.  For example, because 60/40 treatment applies without regard to actual holding period, an investor could engage in tax advantaged investment activities that focus on when contracts subject to Section 1256 produce a better tax result than other investments that are subject to general tax principles.

There is a limited hedging exception from the mark-to-market rules and certain other special rules that apply to Section 1256 contracts that are discussed in IRS Publication 550.  You should consider these rules if you invest in such contracts.

Is all of this new?  No.  In fact, the rules have been in place for over 25 years.  But they could be a surprise to some of you.  They may take some getting used to, but they certainly haven't stopped the continued development of and investment in the futures and options markets.


DISCLAIMER: The information and views set forth in GainsKeeper Tax Topics are general in nature and are not intended as legal, tax, or professional advice. Although based on the law and information available as of the date of publication, general assumptions have been made by GainsKeeper Tax Topics which may not take into account potentially important considerations to specific taxpayers. Therefore, the views and information presented by GainsKeeper Tax Topics may not be appropriate for you. Readers must also independently analyze and consider the consequences of subsequent developments and/or other events. Readers must always make their own determinations in light of their specific circumstances.