Other Financial Products

Foreign futures, precious metals, volatility ETNs, and swaps.

Traders have a bevy of financial products to choose from these days.

Foreign futures

Many foreign brokers promise Americans Section 1256 tax breaks on foreign futures. They mention Commodity Futures Trading Commission (CFTC) “no action letters” granting certain exchanges approval for marketing to Americans. These brokers overlook the other requirement: an IRS revenue ruling granting Section 1256 tax treatment to the foreign futures exchange. Only a handful of exchanges currently have this IRS revenue ruling, including Eurex, LIFFE, ICE Futures Europe, and ICE Futures Canada. (Read our blog Tax Treatment for Foreign Futures to see the list of exchanges with this IRS approval.) Remember, Section 1256 tax treatment uses MTM accounting at year-end. Foreign futures without Section 1256 are reported like securities.

Precious metals

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 12% ordinary income tax brackets pay 0% on long-term capital gains (LTCG); 15% LTCG rate for the middle brackets; and 20% for the top LTCG bracket. This translates to materially higher tax rates on collectibles for all taxpayers in all tax brackets vs. regular LTCG tax rates.

For this reason, some people invest in physical precious metals inside their IRAs. Several years ago, Congress and the IRS loosened the rules allowing IRAs to invest in precious metals.

If collectibles are held one year or less in a taxable account, 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. Precious metals are not securities, so wash-sale loss adjustments, and Section 475 does not apply. Read our blog post: Tax Treatment For Precious Metals.

Volatility Products & Exchange Traded Notes (ETNs)

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 ETF taxed as a security.

Volatility ETNs are structured as “prepaid forward contracts” or as “debt instruments.” Our tax counsel says that an ETN prepaid forward contract is not considered a security by the IRS, whereas, ETN debt instruments are.

Sales of ETN prepaid forward contracts use the realization method on sales. Long-term capital gains rates apply if held 12 months or longer. Because it’s not a security, ETN prepaid forward contracts (i.e., VXX) are not subject to wash-sale loss adjustments and Section 475 (if elected). ETNs debt instruments (i.e., UGAZ) are securities and are subject to wash sale losses and Section 475 (if elected).

There is substantial authority to treat CBOE-listed options on volatility ETNs, and on volatility ETFs structured as publicly traded partnerships as “non-equity options” with Section 1256 treatment. (See our blogs: How To Apply Lower Tax Rates To Volatility Options, and ETNs Have Different Structures With Varying Tax Treatment.)

In preparing Form 1099-Bs, many brokers use the tax classification determined by exchanges for labeling securities vs. 1256 contracts. Some brokers treat both types of ETNs as securities on 1099-Bs, even though prepaid forward contracts do not fall in that category. Some brokers treat CBOE-listed options on volatility ETNs and ETF PTPs as securities on Form 1099-Bs, even though they are eligible for Section 1256 treatment. Taxpayers can depart from 1099-Bs based on substantial authority positions and explain why in a tax return footnote.

Swap contracts

The Dodd-Frank financial regulation law promised to clear private swap transactions on exchanges to protect the markets from another swap-induced financial meltdown — remember those credit default swaps with insufficient margin? When Dodd-Frank was enacted, traders hoped that clearing on futures exchanges would allow Section 1256 tax treatment. They were wrong: Congress and the IRS immediately communicated that Section 1256 would not apply to swap transactions, and they confirmed ordinary gain or loss treatment.

Excerpt from Green’s 2019 Trader Tax Guide.