Section 1256 Contracts

Section 1256 contract traders enjoy lower 60/40 tax rates, summary reporting and no need for accounting.

Section 1256 contracts include:

  • U.S. futures (regulated futures contracts) and options on futures
  • foreign futures with CFTC and IRS approval
  • broad-based indexes and options on broad-based indexes (a broad-based index is one that is made up of 10 or more securities)
  • forward forex in major currencies with the opt-out election into Section 1256(g) (we make a case for spot forex in major currencies, too)
  • options on commodities/futures ETFs taxed as publicly traded partnerships
  • CBOE-listed options on volatility ETNs structured as prepaid forward contracts or debt securities (the ETN itself is not Section 1256)
  • other non-equity options
  • forex OTC options (Wright court)

Section 1256 contracts bring meaningful tax savings. These contracts have lower 60/40 tax rates, meaning 60% (including day trades) are taxed at the lower long-term capital gains rate, and 40% are taxed at the short-term rate, which is the ordinary tax rate. At the maximum tax brackets for 2018 and 2019, the top Section 1256 contract tax rate is 26.8% —10.2% lower than the top ordinary rate of 37%.

For 2018 and 2019 tax returns, there is meaningful tax rate reduction with zero long-term rates in the 10% and 12% ordinary brackets. In the 12% ordinary tax bracket, the blended 60/40 rate is 4.8%. (Here’s the math: 60% LT x 0% LT rate = 0%. Plus, 40% ST x 12% ST rate = 4.8%.) In the 10% ordinary tax bracket, the blended 60/40 rate is 4%. Regular state tax rates apply because they do not include a long-term rate.

Section 1256 contracts are marked-to-market (MTM) on a daily basis. MTM means gain/loss calculations report both realized activity from throughout the year and unrealized gains and losses on open trading positions at year-end. Many traders have small or no open positions on Section 1256 contracts at year-end.

With MTM and summary reporting, brokers are able to issue simple one-page 1099-Bs reporting “aggregate profit or loss on contracts” after taking into account realized and unrealized gains and losses. That amount is reported on Form 6781 Part I, which breaks it down to the 60/40 split and then moves those amounts to Schedule D capital gains and losses.

Unlike securities, Section 1256 contracts have a nifty tax-loss carryback election. On Form 6781, select the “net section 1256 contracts loss election” in box D. Enter, but don’t deduct the loss on the current tax return. Remove the loss from Form 6781 on line 6. Apply the Section 1256 loss on amended tax return filings against Section 1256 gains only. It’s a three-year carryback, and unused amounts are then carried forward.

Instead of day or swing trading the Nasdaq 100 ETF (Nasdaq: QQQ) taxed as a security at ordinary rates, consider trading the Nasdaq 100 emini index (CME: NQ), a Section 1256 contract taxed at lower 60/40 tax rates.

Section 1256 tax rates vs. ordinary rates (2018 & 2019 rates)

Ordinary
Rates
Long-Term
Capital Gains
Rates
40%
Short-Term
Rates
60%
Long-Term
Rates
Blended
60/40
Rates
Savings
In
Rates
10% 0% 4.0% 0% 4.0% 6.0%
12% 0% 4.8% 0% 4.8% 7.2%
22% 15% 8.8% 9% 17.8% 4.2%
24% 15% 9.6% 9% 18.6% 5.4%
32% 15% 12.8% 9% 21.8% 10.2%
35% 15% 14.0% 9% 23.0% 12.0%
37% 20% 14.8% 12% 26.8% 10.2%

Excerpt from Green’s 2019 Trader Tax Guide

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