What Is a Section 1256 Contract?

A Section 1256 contract is a type of investment defined by the Internal Revenue Code (IRC) as a regulated futures contract, foreign currency contract, non-equity option, dealer equity option, or dealer securities futures contract. What makes a Section 1256 contract unique is that each contract held by a taxpayer at the end of the tax year is treated as if it were sold for its fair market value, and gains or losses are treated as either short-term or long-term 澳洲幸运5官方开奖结果体彩网:capital gains.

Understanding Section 1256 Contracts

Here's an instructive example using options trading: A straddle is a strategy that involves holding contracts that offset the risk of loss from each other. For example, if a trader buys both a 澳洲幸运5官方开奖结果体彩网:call option and a 澳洲幸运5官方开奖结果体彩网:put option for the same investment asset at the same time, their investment is known as a straddle.

Section 1256 contracts prevent tax-motivated straddles that would defer income and convert 澳洲幸运5官方开奖结果体彩网:short-term capital gains into 澳洲幸运5官方开奖结果体彩网:long-term capital gains. More specific information about Section 1256 contracts can be found in Subtitle A (Income Taxes), Chapter 1 (Normal Taxes and Surtaxes), Subchapter P (Capital Gains and Losses)🎐, Part IV (Special Rules for Determining Capital Gains and Losses) of the IRC.

The 澳洲幸运5官方开奖结果体彩网:Internal Revenue Service (IRS) is responsible for implementing the IRC.

Mark-to-Market

Traders that trade futures, 澳洲幸运5官方开奖结果体彩网:futures options, and broad-based index options need to be aware of Section 1256 contracts. These contracts, as defined above, must be 澳洲幸运5官方开奖结果体彩网:marked-to-market if held through the end of the tax year. A profit or loss on the 澳洲幸运5官方开奖结果体彩网:fair market value of the contracts should be calculated regardless of whether they we꧋re actually sold for a capi🔜tal gain or a loss.

The mark-to-market profit/loss is actually unrealized but must be reported on the trader's tax return. After the position is closed out in actuality for a 澳洲幸运5官方开奖结果体彩网:realized gain/loss, the amount already reported on a prior tax return is factored in to avoid redundant reports.

Form 6781

Investors report gains and losses for Section 1256 contract investments using Form 6781, but hedging transactions are treated differently. Since these contracts are considered to be sold every year, the 澳洲幸运5官方开奖结果体彩网:holding period of the underlying asset does not determine wh🌊ether or not the gain or loss is short-term or long-term. Rather, all gains and losses on these contracts are considered to be 60% long-term and 40% short🃏-term.

In other words, Section 1256 contracts allow an investor or trader to take 60% of the profit at the more 澳洲幸运5官方开奖结果体彩网:favorable long-term tax rate even if the contract was only held for a year or less.

For example, assume a trader bought a r꧟egulated futures contract on May 5, 2023, for $25,000. At the end of the year, on December 31, they still have the contract in their portfolio and it i🅰s valued at $29,000. Their mark-to-market profit is $4,000. They report this on Form 6781, treated as a 60% long-term and 40% short-term capital gain.

On January 30, 2024, they sell their long position for $28,000. Since they have already recognized a $4,000 gain on their 2023 tax return, they will record a $1,000 loss (calculated as $28,000 minus $29,000) on their 2024 tax return, treated as a 60% long-term and 40% short-term 澳洲幸运5官方开奖结果体彩网:capital loss.

Form 6781 has separate sections for straddles and Section 1256 contracts, meaning that investors have to identify the specific type of investment used🔥. Part I of the form requires Section 1256 investment gains and losses to be reported at either the actual price the investment was sold for or the mark-to-markeꦏt price established on December 31.

Part II of the form requires that the losses on the trader's straddles be reported in Section A and gains calculated in Section B. Part III is provided for any unrecognized gains on positions held at the end of the tax year, but it only has to be completed if a loss is recognized on a position.

The Bottom Line

The purpose of Section 12ღ56 is to prevent traders from manipulating derivatives contracts and/or using them to avoid taxes. Regardless if the contract was sold for a gain or loss, the profit or loss on the fair market value of the contract should be calculated. Consult with a tax advisor for any clarification to ensure you are complying with all tax rules.