Tax Treatment On Financial Products

Which financial products you trade and where you trade them can make a huge difference in tax savings.

Tax treatment of financial products affects investors, traders, and hedge funds. But sadly, many tax preparers overlook important differences in tax treatment for these groups, resulting in overpayments. Education is key. This chapter contains valuable information about how the various instruments are treated come tax time, including securities, Section 1256 contracts, options, ETFs, ETNs, forex, swap contracts, precious metals, cryptocurrencies, volatility products, and foreign futures.

It’s important to distinguish between securities vs. Section 1256 contracts with lower 60/40 capital gains rates vs. other types of financial products like forex or swaps with ordinary income or loss treatment. Plus, there are various elections available to change tax treatment. ETN prepaid forward contracts and cryptocurrencies are taxed similarly to securities using the realization method with short-term vs. long-term capital gains. However, they are not classified as securities by the IRS, which means ETN prepaid forward contracts and cryptocurrencies should not be subject to wash sale losses and Section 475 MTM. The IRS labels cryptocurrencies as “intangible property.”

One might expect that broker-issued 1099-Bs would handle all of these problematic issues, but for some tax treatments, they do not. Some brokers categorize CBOE-listed options on volatility ETNs and ETFs as securities, but there is substantial authority to treat these CBOE-listed options as “non-equity options” included in Section 1256.

Broker compliance rules are different than rules taxpayers must follow on wash-sale loss adjustments on securities. Some brokers mislabel Section 1256 contracts, too. It depends on the taxpayer’s facts and circumstances and elections made as to how the activity is actually reported on the taxpayer’s return. There is no way for every broker to police all their clients’ elections, qualification for trader tax status (TTS), and whether or not they have filed an election for Section 475 MTM on time. Brokers should issue 1099-Bs for the “everyman,” not based on each taxpayer’s individual facts, circumstances and elections filed. This is the reason why it is very important that taxpayers review the 1099-Bs completely and only use the information if it agrees with their particular facts and circumstances and election filed.

Some brokers are willing to issue a Form 1099-B without wash-sale loss adjustments if the trader says he uses Section 475. This practice can be a problem since brokers don’t determine if the trader is eligible for TTS or if he made a timely Section 475 election.

Many financial products like spot forex and cryptocurrencies are not “covered securities” for 1099-B issuance. U.S. cryptocurrency exchanges issue a Form 1099-K (Payment Card and Third Party Network Transactions) to investors who reach a certain threshold of transactions. Brokers issue Form 1099-Bs for securities and Section 1256 contracts to investors and traders.

Capital gains vs. ordinary income

Most financial instruments — including securities, Section 1256 contracts, options, ETFs, ETNs, indexes, precious metals, and cryptocurrencies held as a capital asset — are subject to capital gains treatment. But, some of these financial products qualify as Section 1256 contracts with lower 60/40 capital gains rates. By default, forex contracts and swap contracts are subject to ordinary gain or loss treatment. The distinction between ordinary and capital gains treatment makes a big difference. The capital-loss limitation is a problem for traders and investors who may have trouble using up large capital-loss carryovers in subsequent tax years. Traders with TTS and a Section 475 MTM election have business ordinary-loss treatment, which is more likely to generate tax savings or refunds faster. Some financial products don’t qualify for a Section 475 election, including forex, cryptocurrencies, and ETNs structured as prepaid forward contracts. ETNs structured as debt instruments, however, are securities eligible for Section 475 treatment.

On a mobile device, click “Explore Tax Treatment On Financial Products” above. On a computer, see it on the upper-right. 

Excerpt from Green’s 2019 Trader Tax Guide Chapter 3 Tax Treatment of Financial Products