Update May 8, 2018: Some ETNs, like VELOCITYSHARES 3X LNG NTRL GS ETN (UGAZ), are debt obligations taxed as securities. (Check the tax section of the ETN prospectus.)
These days, volatility can be considered its own asset class, and many types of products have been created to fill this niche. If you trade volatility products, you may have many questions regarding how to treat these items on your tax return. But, guess what? Treatment for these items varies, and some of it is uncertain. Don’t sweat it, though — we are here to provide clarity.
Before delving into the various products and their treatment, it’s important to note that Section 1256 rules apply to “non-equity” options and Section 1256 items receive the coveted lower 60/40 tax rates. (At the maximum tax brackets for 2017, the top Section 1256 contract tax rate is 28% — 12% lower than the top ordinary rate of 39.6%. See 60/40 rates table.)
Several brokerage firms, however, classify options on volatility products as “equity options” taxed as securities. Our CPA firm established a substantial authority position to treat most of these volatility options as non-equity options. Don’t expect brokers to correct 1099-Bs if the tax treatment is uncertain. Be prepared to depart from the 1099-B reporting and include an explanation in footnotes and Form 8275. If your tax savings is significant, it’s wise to obtain a substantial authority opinion from a qualified tax attorney to protect against accuracy-related tax penalties.
CBOE-listed futures on VIX Indexes
Let’s start with a simple one. The CFE-traded VIX futures are “regulated futures contracts” (RFCs) on a qualified board or exchange (QBE). Because Section 1256 includes RFCs, I expect brokers to use Section 1256 for these products. There’s no uncertainty here.
CBOE-listed options on VIX Indexes, ETFs, and ETNs
IRS guidance is unclear, but these general rules should apply.
CBOE-listed options on VIX Indexes are not equity options, referencing a single equity price or narrow-based index of equity prices. They are likely non-equity options included in Section 1256, which references a barometer VIX Index, which does not contain equity prices. Most brokers agree.
CBOE-listed options on VIX securities ETFs, structured as registered investment companies (RICs), are likely equity options because a security ETF RIC acts like a single equity. Most brokers agree.
CBOE-listed options on VIX commodity ETFs, structured as publicly traded partnerships (PTPs), are likely non-equity options because a commodity ETF PTP is not a single equity or narrow-based equity index. Most brokers don’t agree; they treat it as an equity option, and I think you can divert from the broker’s 1099-B to use Section 1256 treatment.
CBOE-listed options on VIX ETNs are likely non-equity options because an ETN is not a single equity or narrow-based equity index. An ETN is a prepaid executory contract. Most brokers don’t agree; they treat it as an equity option, and I think you can divert from the broker’s 1099-B to use Section 1256 treatment.
The values of a narrow-based index must reference actual equity prices. The CBOE-listed options on VIX Indexes do not reference equity prices. Even the CBOE VIX Index for an individual equity (VXAPL) does not reference the equity price of APL, but rather the VIX barometer index for APL. Therefore, it’s likely that VXAPL is also a Section 1256 contract. (See CBOE-listed volatility options.)
Issuers organize volatility ETFs as registered investment companies (RIC) or publicly traded partnerships (PTP). Tax treatment varies by the structure.
Securities ETFs: Securities ETFs are RICs. Selling securities ETF is deemed a sale of a security, calling for short- and long-term capital gains tax treatment using the realization method. RIC ETFs often make short- and long-term capital gains distributions to holders. Brokers report securities ETF proceeds and cost basis for each transaction on Form 1099-B.
Volatility ETFs organized as RICs include:
- REX VolMAXX Long VIX Weekly Futures Strategy ETF (VMAX)
- REX VolMAXX Short VIX Weekly Futures Strategy ETF (VMIN)
Commodities/futures ETFs: These ETFs use the PTP structure, also known as master limited partnerships (MLPs). PTPs issue annual Schedule K-1s passing through income or loss, including Section 1256 income or loss from trading within the PTP. Selling a commodity ETF is deemed a sale of a security, calling for short- and long-term capital gains tax treatment using the realization method.
Taxpayers invested in these ETFs should adjust cost-basis on Form 8949 (capital gains and losses and other income or loss), ensuring they don’t double count Schedule K-1 pass through income or loss. Form 1099-B does not make this cost-basis adjustment, so investors need to make a manual adjustment.
Volatility ETFs organized as PTPs include:
- ProShares VIX Short-Term Futures ETF (VIXY) S&P 500® VIX Short-Term Futures Index
- ProShares VIX Mid-Term Futures ETF (VIXM) S&P 500® VIX Mid-Term Futures Index
- ProShares Ultra VIX Short-Term Futures ETF (UVXY) S&P 500® VIX Short-Term Futures Index
-ProShares Short VIX Short-Term Futures ETF (SVXY) S&P 500® VIX Short-Term Futures Index.
- All are listed on the NYSE Arca securities exchange.
Volatility exchange traded notes
An exchange-traded note (ETN) calculates its rate of return or interest rate based on the movement of an underlying financial instrument, futures index, or equities index. In IRS jargon, most ETNs are a “prepaid executory contract” or “prepaid forward contract” based on the relevant financial instrument or index. (A few ETNs are debt instruments, see more below.)
Report ETN income when realized (sold) as short- and long-term capital gains and losses. Exception: Report currency ETNs with Section 988 ordinary gain or loss treatment.
ETNs structured as prepaid forward contracts are not a security or a commodity, so they should not qualify for Section 475 ordinary gain or loss treatment used by traders eligible for trader tax status and who elected Section 475 on time.
Section 1091 wash sale loss rules apply to securities. ETNs, structured as prepaid forward contracts, are not securities, so they should be exempt from wash sale loss adjustments. Most 1099-Bs treat ETNs as securities, subjecting them to wash sale losses. Consider departing from the 1099-B, explain why on Form 8275, and in some cases, get a substantial authority opinion letter from a tax attorney.
The ETN holder does not own an underlying instrument or futures index, so he or she should not use Section 1256 treatment. In the VXX ETN prospectus, the tax attorneys suggested reasons why the IRS might apply Section 1256 as “possible alternative” tax treatment. But, they did not imply investors should try to use Section 1256 treatment. Our firm’s tax attorneys researched whether there is “substantial authority” for the position that 1256 applies to VXX and they concluded there is no substantial authority. (Read our rationale in our blog post: Tax Treatment For Exchange Traded Notes (ETNs))
Some ETNs, like VELOCITYSHARES 3X LNG NTRL GS ETN (UGAZ), are actual debt instruments, which are taxed as securities, and not prepaid forward contracts. Our tax attorney Roger Lorence says, “The tax treatment of ETNs is often difficult to determine. You have to review the tax section of each prospectus. In many cases, the offering is an undivided interest in the underlying positions, such as futures, so that the ETN is not an interest in an entity nor itself a security. However, other ETNs are structured as a debt instrument, usually with leverage with respect to some index (such as natural gas futures). In my experience “ETN” is a confusing and largely useless label and you have to go deeper to determine the tax characteristics.”
Volatility ETN products include:
In order of volume http://etfdb.com/etfdb-category/volatility/
- iPath S&P 500 VIX ST Futures ETN (VXX)
- iPath S&P 500 VIX Mid-Term Futures ETN (VXZ)
- UBS VelocityShares 1X Daily Inverse VSTOXX Futures ETN (EXIV)
- UBS VelocityShares VIX Variable Long/Short ETN (LSVX)
- UBS VelocityShares VIX Tail Risk ETN (BSWN)
- UBS VelocityShares 1X Long VSTOXX Futures ETN (EVIX)
- iPath S&P 500 Dynamic VIX ETN (XVZ)
- Credit Suisse VelocityShares Daily Long VIX Short-Term ETN (VIIX)
Listed on securities exchanges: NYSE, Nasdaq, or Bats.
Options on volatility ETNs
The CBOE lists options on VXX (ETN). An IRS official in the Chief Counsel’s office for financial products explained to our tax attorney Roger D. Lorence that any option listed on CBOE or other qualified board or exchange whose reference is not a single symbol or a narrow-based index is a non-equity option in Section 1256. The equity option definition has two different prongs: single (equity) symbol and narrow-based (equity) index. Using this rationale, the IRS official said the option on VXX (ETN) is a non-equity option in Section 1256.
As mentioned earlier, our CPA firm established a substantial authority (SA) position to use Section 1256 tax treatment for CBOE-listed options on VIX Indexes, volatility ETF PTP, and ETNs (i.e., VXX). SA means it’s 33% likely to be correct, so tax preparers can sign a tax return including that position and avoid accuracy-related tax penalties.
If you are interested, contact our CPA firm at email@example.com.
Roger Lorence JD and Darren Neuschwander CPA contributed to this content.
Attend our Webinar on Sep. 12, 2017, or watch the recording: Tax Treatment For Volatility Products: Options, Futures,ETFs, and ETNs