Section 1256 Contracts
Section 1256 contract traders enjoy lower 60/40 tax rates, summary reporting and no need for accounting.
- 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 with the opt-out election into Section 1256g on the main currencies, for which futures trade (we make a case for spot forex too)
- options on commodities/futures ETFs taxed as publicly traded partnerships
- other non-equity options
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 bracket for 2017, the top Section 1256 contract tax rate is 28% — 12% lower than the top ordinary rate of 39.6%. At the maximum tax bracket for 2018, the blended 60/40 rate is 26.8% — 10.2% lower than the highest ordinary rate of 37%.
For 2017: With zero long-term rates in the 10% and 15% ordinary brackets, there is meaningful tax rate reduction throughout the brackets. In the 15% ordinary tax bracket, the blended 60/40 rate is 6%. (Here’s the math: 60% LT x 0% LT rate = 0%. Plus, 40% ST x 15% ST rate = 6%.) In the 10% ordinary tax bracket, the blended 60/40 rate is 4%. (See our Table “Section 1256 tax rates vs. ordinary rates (2017 rates)” below.)
States don’t apply a long-term rate, so regular state tax rates apply.
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 contracts are marked-to-market (MTM) on a daily basis
MTM means you report both realized and unrealized gains and losses 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.
Section 1256 contracts have a nifty tax-loss carryback election
On Form 6781, select the Section 1256 loss carryback election but don’t enter the loss on the current year tax return. Instead, on amended tax return filings, apply the loss against Section 1256 gains only. It’s a three-year carryback and unused amounts are then carried forward.
Section 1256 tax rates vs. ordinary rates (2017 rates)
For more in-depth information on Section 1256 contract tax treatment, read Green’s 2018 Trader Tax Guide.