Tag Archives: tax treatment

Short Sellers Should Not Rely On Brokers For IRS Reporting (Recording)

September 19, 2016 | By: Robert A. Green, CPA

Traders are on their own when it comes to tax compliance for short sales. Brokers don’t report constructive sales on appreciated financial positions on 1099-Bs, and many miscategorize stock borrowing fees as interest expenses.

Join trader tax expert Robert A. Green, CPA as he explains complicated tax rules for short sale transactions and expenses:

– Short sales against the box.
– Constructive sales on appreciated positions.
– Special rules for short-term vs. long-term capital gains and losses.
– Using tax compliant software.
– Dividends and “payments in lieu” of dividends.
– Stock borrow fees vs. interest expenses.
– Investors face limitations on deductions.
– Traders with trader tax status & Section 475 bypass short sale problems.
– Tax compliance tips and examples.

Tax Treatment For Volatility Products Including ETNs

June 27, 2016 | By: Robert A. Green, CPA

Click to read Green's blog post in Forbes.

Click to read Green’s blog post in Forbes.

After the Brexit referendum vote on June 24, 2016, volatility-based financial products skyrocketed in price, and by Monday, June 27, prices had subsided. That’s volatility!

There are many different types of volatility-based financial products to trade, and tax treatment varies. For example, CBOE Volatility Index (VIX) futures are taxed as Section 1256 contracts with lower 60/40 MTM tax rates. The NYSE-traded SVXY is an exchange-traded fund (ETF) taxed as a security. The iPath S&P 500 VIX Short-Term Futures (VXX) is an exchange-traded note (ETN), and while tax treatment is similar to an ETF, there is uncertain tax treatment on ETNs. I focus this blog post on tax treatment for ETNs.

How ETN’s work
Per TAX STRATEGIES FOR LONG-SHORT EQUITY, Practical Tax Strategies, Sep 2014: “An exchange traded note (ETN) can be linked directly to an active index. An ETN is similar to a bond except the interest rate is replaced with the return of an index.” “ETNs include significant creditor risks because they are not backed by underlying assets, but only by the issuer’s ability to pay at maturity (which may be 30 years in the future).” This creditor risk probably increased after the Brexit vote, as many of these banks operate in the U.K. and European Union. Day traders are not as concerned with creditor risks.

VXX prospectus discusses tax treatment
In the prospectus for iPath® S&P 500 VIX Short-Term Futures ETN, tax attorneys write “by purchasing the ETNs you agree to treat the ETNs for all U.S. federal income tax purposes as a pre-paid executory contract with respect to the applicable Index. If the ETNs are so treated, you should generally recognize capital gain or loss upon the sale, early redemption or maturity of your ETNs in an amount equal to the difference between the amount you receive at such time and your tax basis in the ETNs. The U.S. federal income tax consequences of your investment in the ETNs are uncertain.”

Tax publishers use a similar term: “prepaid forward contracts” and tax treatment calls for deferral of taxes until sale and long-term capital gains rates if held 12 months. Constructive receipt of income rules prevents tax avoidance with offsetting positions.

Traditionally, ETN’s are tax advantaged because they allow deferral until realization (sale) and lower long-term capital gains rates if held 12-months. That’s good for investors. But, day and swing traders don’t benefit from deferral and long-term rates; they incur short-term capital gains taxes throughout the year taxed at ordinary rates.

Traders would rather have the option of using Section 1256 tax treatment on volatility ETNs including lower 60/40 capital gains rates. That’s how the IndexCBOE: VIX is taxed. (60% is lower long-term capital gains rates up to 20%, even on day trades, and the other 40% are short-term capital gains at ordinary rates.) Section 1256 also requires mark-to-market (MTM) accounting, imputing sales on open positions at year-end and that’s not a problem for day traders.

IRS ruling
The IRS caused questions when it issued Rev. Rul 2008-1 about foreign currency linked ETN’s. The IRS also issued Rev. Ruling 2008-2 asking for comments on prepaid forward contracts and similar arrangements. The IRS has not yet issued final guidance on ETN’s.

In Rev. Ruling 2008-1, the IRS “looked through” the currency ETN to the underlying market bet on the Euro and market interest rates. The IRS objected to the ETN benefiting from tax deferral and long-term capital gains rates when the underlying foreign currency transactions (Section 988) would require ordinary gain or loss treatment. Plus, debt instruments require accrual of annual interest income. The IRS knows that traditional ETN tax treatment prejudices Treasury, and it would prefer to accrue income and use ordinary rather than capital gains tax rates.

ETFs based on volatility
The IRS can’t apply this same look through logic to ETF’s because as a “registered investment company” (RIC), security ETF’s are taxed as securities.  A commodity ETF can’t use the RIC structure; it’s a publically traded partnership also taxed as securities. A commodity ETF issues a Schedule K-1 passing through Section 1256 contract income or loss.

ProShares has three volatility ETF’s: ULTRA VIX SHORT-TERM FUTURES ETF (NYSEArca: UVXY), SHORT VIX SHORT-TERM FUTURES ETF (NYSEArca: SVXY), and VIX SHORT-TERM FUTURES ETF (NYSEArca: VIXY).  These ProShares ETF’s are taxed as securities: Unlike ETN’s, ETF RIC’s make annual distributions of income and capital gains to shareholders. ETF’s don’t provide as much deferral as ETN’s.

Possible alternative tax treatments for ETN’s
In the VXX prospectus, tax attorneys suggest that Section 1256 is a “possible alternative” tax treatment. “Moreover, it is possible that the IRS could seek to tax your ETNs by reference to your deemed ownership of the Index components. In such a case, it is possible that Section 1256 of the Internal Revenue Code could apply to your ETNs, in which case any gain or loss that you recognize with respect to the ETNs that is attributable to the regulated futures contracts represented in the applicable Index could be treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss, without regard to your holding period in the ETNs… And, currently, accrue ordinary interest income in respect of the notional interest component of the applicable Index.”

Postscript: In my July 11, 2017, blog post How To Avoid Tax Reporting Trouble With Exchange Traded Notes, I explain there is no substantial authority for ETN holders to use Section 1256 tax treatment.

Options on VXX (added Dec. 16, 2016)
After writing this blog post, some clients asked me how options on VXX are treated for tax purposes. I got this reply from our tax attorney Roger Lorence. “I located nothing directly on point. However, the better view in my understanding would be that these options are nonequity options and therefore Section 1256 contracts. The options are listed on CBOE and are therefore listed options on a qualified board or exchange. The underlying is, e.g., VXX ETNs. The tax opinion in the prospectus for the ETNs (Sullivan and Cromwell) is that these are prepaid forward contracts and the holder has an executory contract for the delivery of the underlying futures contracts.  Therefore the CBOE listed options are a derivative contract several levels removed from the ultimate underlying. If a holder were to exercise the CBOE options theoretically, they would not receive equity in a single stock or a narrow-based group of stocks based on a narrow-based index.”

When traders talk about volatility products, they often conflate tax treatments. Until we get further formal guidance from the IRS, the tax treatment on volatility and other ETN’s is uncertain. Consult with a trader tax expert.

Darren Neuschwander, CPA contributed to this blog post.

Tax Treatment For Trading Options

May 27, 2015 | By: Robert A. Green, CPA

forbes_logo_main

Options trading is proliferating with the advent and innovation of retail option trading platforms, brokerage firms and trading schools. A trader can open an options trading account with just a few thousand dollars vs. $25,000 required for “pattern day trading” equities (Reg T margin rules).

Options trading provides the opportunity to make big profits on little capital using “risk it all” strategies. Options are a “tradable” financial instrument and a way to reduce risk with hedging strategies. When it comes to option taxation, complex trades with offsetting positions raise complex tax treatment issues like wash sale and straddle loss deferral rules.

Investors also trade options to manage risk in their investment portfolios. For example, if an investor owns significant equity in Apple and Exxon, he or she may want to trade options to manage risk or enhance income on long equity positions. He or she can collect premium by selling or “writing” an options contract or buy a “married put” for portfolio insurance. Traders also use ETFs and indexes for portfolio-wide insurance. (Investopedia has explanations for different option trading strategies.)

Simple vs. complex option trades
There are simple option trading strategies like buying and selling call and put options known as “outrights.” And there are complex option trades known as “option spreads”which include multi-legged offsetting positions like iron condors; butterfly spreads; vertical, horizontal and diagonal spreads; and debit and credit spreads.

Tax treatment for outright option trades is fairly straightforward and covered below. Tax treatment for complex trades triggers a bevy of complex IRS rules geared toward preventing taxpayers from tax avoidance schemes: deducting losses and expenses from the losing side of a complex trade in the current tax year while deferring income on the offsetting winning position until a subsequent tax year.

Look to the underlying financial instrument tax treatment
Options are “derivatives” of underlying financial instruments including equities, ETFs, futures, indexes, forex, and more. The first key to determining an option’s tax treatment is to look at the tax treatment for its underlying financial instrument. The option is to buy or sell that financial instrument and it’s tied at the hip.

For example, an equity option looks to the tax treatment of equities, which are considered “securities.” Conversely, options on Section 1256 contracts are deemed “non-equity options.”

ETFs are taxed as securities, so options on securities ETFs are taxed as securities. Options on commodity ETFs (structured as publicly traded partnerships) are non-equity options taxed as Section 1256 contracts. Options on futures are taxed as futures, which are Section 1256 contracts.

Capital gains and losses for securities are reported when realized (sold or closed). Conversely, Section 1256 contracts are marked-to-market (MTM) at year-end and they benefit from lower 60/40 capital gains tax rates: 60% long-term and 40% short-term. MTM imputes sales on open positions at market prices so there is no chance to defer an offsetting position at year-end. Generally, that means wash sale and straddle loss deferral rules don’t apply to Section 1256 options.

There are three things that can happen with outright option trades:

  • Trade option (closing transaction)
    Trading call and put equity options held as a capital asset are taxed the same as trading underlying equities. Report proceeds, cost basis, net capital gain or loss and holding period (short-term vs. long-term held over 12 months) from realized transactions only on Form 8949 (Capital Gains & Losses).
  • Option expires (lapses)
    There’s a minor twist on the above scenario. Rather than realizing a dollar amount on the closing out of the option trade, the closeout price is zero since the option expires worthless.Use zero for the realized proceeds or cost basis, depending on whether you’re the “writer”or “holder” of the option and if it’s a call or put. Use common sense — collecting premium on the option trade is proceeds and therefore the corresponding worthless exercise represents zero cost basis in this realized transaction. For guidance on entering option transactions as “expired”on Form 8949, read IRS Pub. 550 – Capital Gains And Losses: Options.
  • Exercise the option
    This is where tax treatment gets more complicated. Exercising an option is not a realized gain or loss transaction; it’s a stepping-stone to a subsequent realized gain or loss transaction on the underlying financial instrument acquired. The original option transaction amount is absorbed (adjusted) into the subsequent financial instrument cost basis or net proceed amount.Per IRS Pub. 550 Capital Gains & Losses: Options: “If you exercise a call, add its cost to the basis of the stock you bought. If you exercise a put, reduce your amount realized on the sale of the underlying stock by the cost of the put when figuring your gain or loss. Any gain or loss on the sale of the underlying stock is long term or short term depending on your holding period for the underlying stock…If a put you write is exercised and you buy the underlying stock, decrease your basis in the stock by the amount you received for the put…If a call you write is exercised and you sell the underlying stock, increase your amount realized on the sale of the stock by the amount you received for the call when figuring your gain or loss.” Some brokers interpret IRS rules differently, which can lead to confusion in attempting to reconcile broker-issued Form 1099Bs to trade accounting software. A few brokers may reduce proceeds when they should add the amount to cost basis. Equity options are reportable for the first time on 2014 Form 1099Bs.Exercising an option gets to the basics of what an option is all about: it’s the right, but not the obligation, to purchase or sell a financial instrument at a fixed “strike price” by an expiration date. Exercise may happen at any time until the option lapses. An investor can have an in the money option before expiration date and choose not to execute it, but rather hold or sell it before expiration.
  • Holding period for long-term capital gains
    When an equity option is exercised, the option holding period becomes irrelevant and the holding period for the equity begins anew. The holding period of the option doesn’t help achieve a long-term capital gain 12-month holding period on the subsequent sale of the equity. When an option is closed or lapsed, the option holding period does dictate short- or long-term capital gains treatment on the capital gain or loss.With exceptions recapped in IRS Pub. 550: “Put option as short sale.  Buying a put option is generally treated as a short sale, and the exercise, sale, or expiration of the put is a closing of the short sale. If you have held the underlying stock for one year or less at the time you buy the put, any gain on the exercise, sale, or expiration of the put is a short-term capital gain. The same is true if you buy the underlying stock after you buy the put but before its exercise, sale, or expiration.”

Complex trades lead to complex tax treatment issues
In general, if an investor has an offsetting position he or she should look into more complex tax treatment issues.

Offsetting Positions
IRS Pub. 550: Capital Gains & Losses: Straddles defines an “offsetting position” as “a position that substantially reduces any risk of loss you may have from holding another position.”

In the old days, shrewd professional options traders would enter offsetting positions and close out the losing side before year-end for a significant tax loss and let the winning side remain open until the subsequent year. They used this strategy to avoid paying taxes. The IRS goes through (and causes) great pains to prevent this type of tax avoidance. Offsetting position rules included “related persons” including a spouse and your flow-through entities.

“Loss Deferral Rules”in IRS Pub. 550 state “Generally, you can deduct a loss on the disposition of one or more positions only to the extent the loss is more than any unrecognized gain you have on offsetting positions. Unused losses are treated as sustained in the next tax year.”

IRS enforcement of offsetting position rules
Frankly, the offsetting position rules are complex, nuanced and inconsistently applied. There are insufficient tools and programs for complying with straddle loss deferral rules. Brokers don’t comply with taxpayer wash sale rules or straddle loss deferral rules on Form 1099Bs or profit and loss reports. Few local tax preparers and CPAs understand these rules, let alone know how to spot them on client trading records.

The IRS probably enforces wash sale and straddle loss deferral rules during audits of large taxpayers who are obviously avoiding taxes with offsetting positions. They make a lot of money, but it’s always deferred to the next tax year. The IRS doesn’t seem to be questioning wash sales and straddles during exams for the average Joe Trader.

I expect the IRS will launch a tax exam initiative for measuring taxpayer compliance with new cost-basis reporting law and regulations. I see a big problem brewing with unreconciled differences between taxpayer and broker rules on wash sales.

Wash sales
As we stress in our extensive content on wash sale loss deferral rules, Section 1091 rules for taxpayers require wash sale loss treatment on substantially identical positions across all accounts including IRAs. Substantially identical positions include Apple equity, Apply options and Apple options at different expiration dates on both puts and calls.

If a taxpayer re-enters a substantially identical position within 30 days before or after existing a position, the IRS defers the tax loss by adding it to the cost basis of the replacement position. When a taxable account has a wash sale caused by a replacement position purchased in an IRA, the wash sale loss is permanently lost.

Cost-basis regulations phased-in options as “covered securities” starting with 2014 Form 1099Bs. Brokers report wash sales based on identical positions, not substantially identical positions. Investors who trade equities and equity options cannot solely rely on Form 1099Bs and they should use their own trade accounting software to generate Form 8949. Learn more about wash sales in our Trader Tax Center.

Straddle loss deferral rules
Options traders use option spreads containing offsetting positions to limit risk and provide a reasonable opportunity to make a net profit on the trade. That’s very different from an unscrupulous trader entering a complex trade with offsetting positions set up for no overall risk (the rule is substantially reduced risk) or reward. Why would an options trader do that? For tax avoidance reasons only.

The IRS straddle loss deferral rules are set up to catch this trader and prevent this type of tax avoidance. The straddle loss deferral rule defers a loss to the subsequent tax year when the winning side of the position is closed, thereby reversing what the unscrupulous trader was trying to achieve. The IRS also suspends holding period so it’s impossible to qualify for long-term capital gains rates in the following year, too. Transaction-related expenses (carrying costs) and margin interest (certain interest) are also deferred by adding them to the cost-basis of the offsetting winning position.

Learn more about straddle loss deferral rules in connection with options in IRS Pub. 550: Capital Gains & Losses: Straddles. “A straddle is any set of offsetting positions on personal property. For example, a straddle may consist of a purchased option to buy and a purchased option to sell on the same number of shares of the security, with the same exercise price and period. Personal property. This is any actively traded property. It includes stock options and contracts to buy stock but generally does not include stock. Straddle rules for stock. Although stock is generally excluded from the definition of personal property when applying the straddle rules, it is included in the following two situations. 1) The stock is of a type which is actively traded, and at least one of the offsetting positions is a position on that stock or substantially similar or related property. 2) The stock is in a corporation formed or availed of to take positions in personal property that offset positions taken by any shareholder.”

Straddle loss rules are complex and beyond the scope of this blog post. Consult a tax adviser who understands the rules well.

Caution to unsuspecting option traders
Active traders in equities and equity options entering complex trades with multi-legged offsetting positions may unwittingly trigger straddle loss deferral rules if they calculate risk and reward wrong and there is substantially no risk.

Section 475 MTM
Traders who qualify for trader tax status may elect Section 475(f) MTM accounting, provided they do so by the deadline. MTM means the trader reports unrealized gains and losses on trading positions at year-end by imputing sales at year-end prices. Segregated investment positions are excluded from MTM. The character of the income changes from capital gain and loss to ordinary gain or loss. Section 475 trades are exempt from Section 1091 wash sale rules and straddle loss deferral rules since no open positions are deferred at year-end.

Employee stock options
Don’t confuse tradable options with employee stock options. When an employee acquires non-qualified options on his employer’s stock (equity), the later exercise of those options triggers ordinary income reported on the employee W-2 because the appreciated value is considered a form of wage compensation.

Other resources
Ernst & Young prepared a useful guide with a good section on options taxation. It was requested by The Options Industry Council and is available on the CBOE website at https://www.cboe.com/LearnCenter/pdf/TaxesandInvesting.pdf.

Tax Treatment For Precious Metals

January 7, 2015 | By: Robert A. Green, CPA

forbes_logo_main

The collectibles tax rate on precious metals is high, learn how to improve after-tax returns.

There are many different ways to invest in precious metals and tax treatment varies.

Physical precious metals are “collectibles” which are a special class of capital assets. If collectibles are held over one year (long-term), sales are taxed at the “collectibles” tax rate — the taxpayer’s ordinary rate capped at 28%.

It’s different for regular capital assets like securities: individuals in the 10% and 15% ordinary income tax brackets pay 0% on long-term capital gains (LTCG); individuals in the 25%, 33% and 35% tax brackets pay 15% on LTCG; and individuals in the top 39.6% bracket pay 20% on LTCG.

This translates to materially higher tax rates on collectibles for all taxpayers in all tax brackets vs. regular LTCG tax rates. For this reason, many CPAs recommend clients invest in physical precious metals inside their IRAs. Congress and the IRS loosened the rules allowing IRAs to invest in precious metals.

If collectibles are held one year or less, the short-term capital gains ordinary tax rate applies no different from the regular STCG tax rate. Realized gains and losses in collectibles are reported on Form 8949 and Schedule D along with other capital gains and losses, which means the capital loss limitation of $3,000 against ordinary income applies on individual tax returns. There are special ordering rules for collectibles vs. other capital asset classes.

If you prefer the regular LTCG rate in your taxable accounts, you can get exposure to precious metals by investing in securities tied to the precious metals industry. These securities are no different from other securities with STCG up to 39.6% and LTCG rates up to 20%.

Traders appreciate precious metal futures since they are Section 1256 contracts with lower 60/40 tax rates and mark-to-market (MTM) accounting on a daily basis. Sixty percent is LTCG and 40% is STCG for a top blended rate of 28%, which is 12% less than the top STCG rate. MTM means you report both realized and unrealized gains and losses. The $3,000 capital loss limitation still applies. Alternatively, you may file a Section 1256 loss carryback election on top of Form 6781 when filing your tax return.

More about collectibles
When you invest in physical precious metals including bullion (coins and bars) or physical-backed precious metals ETFs — structured as grantor trusts which means you effectively own the bullion — the “collectibles” tax rate and rules apply.

Per Thomson Reuters Checkpoint tax research service:

  • “Collectibles gain or loss is gain or loss from the sale or exchange of a collectible which is a capital asset held for more than one year, but only to the extent such gain or loss is taken into account in computing gross income. (Code Sec. 1(h)(5)). Any work of art, rug or antique, (precious) metal or gem, stamp or coin, alcoholic beverage, or any other tangible personal property specified by IRS for this purpose is a collectible.” Precious metals jewelry meets the definition of collectibles.
  • “The term 28% rate gain means the sum of collectibles gain and losses and section 1202 gain (certain qualified small business stock), less the sum of collectibles loss, the net short-term capital loss for the tax year, and the long-term capital loss carryover to the tax year.RIA observation:As a result of the way the 28% rate gain is defined, a long-term capital loss carryover from an earlier tax year will always be used first to offset it.”

Examples: If X sells a collectible after one year and is in a low ordinary income tax bracket of 15%, then the collectibles tax rate is 15%. Conversely, if Y is in the ordinary tax bracket of 33%, the collectibles ordinary rate is capped at 28%. It’s not a blanket 28% rate for all taxpayers.

Nonphysical precious metal investments
If you want to avoid the higher collectibles tax rate and benefit from lower LTCG rates, consider investing in securities tied to precious metals, but not physically backed by precious metals.

For example, the popular gold ETF symbol GLD is a physical-backed precious metal ETF structured as a grantor trust and it’s deemed a collectible. Conversely, the gold mining ETF symbol GDX is a registered investment company (RIC) taxed as a security.

Here are some other examples of securities tied to precious metals: gold mining equities like symbols ABX and GG, gold mining ETFs (RICs) like GDXJ, gold mutual funds (RICs) like symbols SGGDX and TGLDX and gold mining exchange-traded notes (ETNs — debt securities) like symbols UBG and TBAR. Securities are not a pure-play investment in precious metals.

U.S. closed end funds (CEF) are also trusts treated as collectibles. But non-U.S. closed end funds like symbols CEF and GTU are offshore corporations subject to Passive Foreign Investment Company (PFIC) rules. For PFICs, consider a “qualified electing fund election” under Section 1295 filed on Form 8621 to enjoy LTCG tax rates. But unless you are making a significant investment, it may not be worth the extra tax red tape and oversight.

Section 1256 lower 60/40 capital gains tax rates
Traders always like Section 1256 because they get lower 60/40 tax rates even on fast trades; they don’t have to wait one year for lower LTCG rates. Gold futures contracts on U.S. futures and commodities exchanges qualify for Section 1256 tax treatment as regulated futures contracts (RFCs).

In their Journal of Accountancy article “Tax-Efficient Investing in Gold” dated Jan. 1, 2015, Steven H. Smith, Ph.D. and Ron Singleton, CPA, Ph.D. write that its also popular to invest in gold futures ETFs like symbols DGL and UGL, and gold futures ETNs. Our content on ETFs points out that sales of commodities/futures ETFs — structured as publically traded partnerships — are taxed like securities. Investors often receive a Schedule K-1 passing through Section 1256 contract income which requires an adjustment to cost basis as part of a sale transaction.

Breaking news from the IRS on IRAs and precious metals
Per Thomson Reuters tax service on Jan. 7, 2015, “IRAs can invest in trusts holding gold: In a private ruling, the IRS held that IRAs and individually directed accounts maintained by qualified retirement plans can invest in trusts holding gold without being treated as a distribution under IRC Sec. 408(m) (1). According to the IRS, the rules that prohibit direct investments by IRAs in gold do not apply if the gold is held by an independent trustee. In this ruling, shares in the trust are marketed to the public, including IRAs and individually directed plans, and are traded on a stock exchange. However, if the shares are redeemed for gold, the IRS says the exchange will be treated as an acquisition of a collectible (i.e., treated as a taxable distribution to the owner) except to the extent IRC Sec. 408(m)(3) is satisfied. PLR 201446030.”

The trend is your friend
When IRAs were created in 1974, Congress prohibited IRA investments in collectibles. In 1986, Congress allowed U.S. gold and silver coin investments and in 1998 it expanded that to pure (99.5%) bullion. In 2007, the IRS issued a PLR 200732026 that did not consider physical-backed precious metal ETFs like the GLD a collectible as held by IRAs — a clever way around the prohibition.

Expenses
Owning significant gold bullion requires expenses for storage and insurance. Holding a few gold coins in a safe deposit box has negligible cost. Even with securities and futures tied to precious metals, expenses are factored into the investment structures. Try to have IRAs and retirement plans pay their own investment expenses.

Bottom line
The price of gold had huge appreciation in the decade ending in 2012 and it’s been a rocky road down in price since then with volatility. Don’t lose sight of tax losses and the dreaded capital loss limitation, which applies to collectibles, precious-metal-tied securities and futures. At least you’ll get the benefit of losses inside a traditional IRA or retirement plan since it reduces your taxable distributions in retirement.

Postscript Feb. 26, 2015 about the option on GLD ETF
Many tax professionals treat the option on GLD (gold ETF) as a Section 1256 contract principally because it’s a non-equity option trading on a CFTC qualified board of exchange. Options on commodity ETFs structured as publicly-traded partnerships (PTP) are Section 1256 contracts. The GLD is a publicly-traded grantor trust, not a PTP. We understand that on their 2014 Form 1099Bs, Fidelity is treating the option on GLD as a stock option (a security) perhaps because if a taxpayer sells physical gold short term it’s a short-term capital gain just like a security. This may relate to the GLD being a grantor trust with disregarded ownership of the underlying assets – as if the owner of the ETF owns the gold bullion directly. A well respected tax information site Twenty-First.com lists the option on GLD as Section 1256 and it states “If the ETF is not set up as a RIC, but as a trust (like GLD) or a limited partnership (like USO), then listed options on the ETF would be treated as a non-equity option under Section 1256.” Click here for our content on ETFs.

Options

August 28, 2014 | By: Robert A. Green, CPA

Options cover the gamut of tax treatment. They are a derivative of their underlying instrument and generally have the same tax treatment. For example, equity options are a derivative of the underlying equity, and both are securities. Tax treatment for options is diverse, including simple (outright) and complex trades with multiple legs.

Options taxed as securities:

  • equity (stock) options
  • options on narrow-based indexes
  • options on securities ETFs RIC

Options taxed as 1256 contracts:

  • non-equity options (a catchall)
  • options on U.S. regulated futures contracts and broad-based indexes
  • CBOE-listed options on commodity ETF publicly traded partnerships
  • CBOE-listed options on precious metals ETF publicly traded trusts
  • CBOE-listed options on volatility ETN prepaid forward contracts
  • forex OTC options (Wright appeals court)

Generally, options listed on a commodities exchange, labeled a “qualified board or exchange” (QBE), are a 1256 contract unless the reference is a single stock or a narrow-based stock index.

For options taxed as securities, wash-sale loss rules apply between substantially identical positions in securities, which means between equity and equity options, such as Apple stock and Apple stock options, at different expiration dates. (These are IRS WS rules for taxpayers, which are broader than for brokers on 1099-Bs). Because wash-sale loss rules only apply to securities, they do not apply to options taxed as Section 1256 contracts.

Simple vs. complex options trades. Simple option trading strategies like buying and selling call-and-put options are known as outrights. Complex options trades known as option spreads include multi-legged offsetting positions like iron condors; butterfly spreads; vertical, horizontal, and diagonal spreads; and debit and credit spreads.

Tax treatment for outright option trades is relatively straightforward. However, complex options trades trigger a bevy of IRS rules geared toward preventing taxpayers from tax avoidance schemes: deducting losses and expenses from the losing side of the trade in the current tax year while deferring income on the offsetting winning position until a subsequent tax year.

Three things can happen with outright option trades: For more information, see Green’s Trader Tax Guide.