Section 1256 contracts include certain regulated futures contracts, foreign currency contracts and non-equity options. These contracts receive a unique tax treatment under the IRS code and are subject to mark-to-market accounting, meaning that all open positions are treated as if they were sold at fair market value at the end of the tax year. This can impact an investor’s tax obligations by requiring unrealized gains and losses to be reported annually.

A financial advisor can help manage taxes on 1256 contracts and develop other strategies for your investment plan.

What Is a Section 1256 Contract?

A Section 1256 contract is a financial instrument with special tax rules under IRS Code Section 1256. These contracts are traded on regulated exchanges and follow specific tax treatment. Section 1256 contracts include:

• Regulated futures contracts. Futures contracts traded on U.S. exchanges that meet IRS regulations.
• Non-equity options. Options contracts that are based on assets other than individual stocks, such as commodities or indexes.
• Foreign currency contracts. Certain forward contracts involving foreign currency trades.
• Dealer equity options and dealer securities futures contracts. Contracts traded by market makers and dealers in securities and derivatives.

One of the primary advantages of Section 1256 contracts is their favorable tax treatment. Profits and losses are taxed using a 60/40 split, meaning that 60% of gains are taxed at the lower long-term capital gains rate, while 40% are taxed at the higher short-term rate. This is a significant tax advantage when compared with standard stock trading, where short-term capital gains are taxed as ordinary income.

How Section 1256 Contracts Work

To explain how the tax treatment for a Section 1256 contract works, let’s take a look at a more-detailed example. Suppose an investor buys a regulated futures contract for $10,000. By December 31, the contract’s fair market value rises to $12,000, but the investor does not sell. Under Section 1256 rules, they must report a $2,000 gain on their tax return for that year. If the value decreases the following year, they can report the loss, even if they do not close the position. Here are three things that investors should know about Section 1256 contracts:

• Mark-to-market accounting. On December 31 of each year, all open contracts are treated as if they were sold and repurchased at their fair market value. Any gains or losses are recognized for tax purposes, regardless of whether the investor has actually closed the position.
• 60/40 tax treatment. Gains and losses are split 60% long-term and 40% short-term, which can significantly reduce tax liabilities compared to traditional trading.
• Loss carryback provision. If a taxpayer has a net loss from Section 1256 contracts, they can elect to carry back the loss up to three years to offset gains from previous years, potentially resulting in a tax refund.

How to File Form 6781 for Section 1256 Contracts

Here are seven general steps to file Form 6781 and report gains or losses from Section 1256 contracts for tax purposes:

1. Obtain a summary of trading activity. Gather trade confirmations, brokerage statements and mark-to-market valuations for all Section 1256 contracts.
2. Complete Part I of Form 6781. List the total net gains or losses from Section 1256 contracts, including both realized and unrealized amounts.
3. Apply the 60/40 tax treatment. The IRS automatically divides the total gain or loss into 60% long-term and 40% short-term capital treatment.
4. Complete Part II if applicable. If trading involved straddle positions, additional calculations may be required.
5. Elect loss carryback if necessary. If the tax year resulted in a net loss, an election can be made to carry back the loss and amend prior tax returns.
6. Transfer totals to Schedule D. The calculated amounts from Form 6781 must be transferred to Schedule D (capital gains and losses) on the Form 1040 tax return.
7. Attach Form 6781 to the tax return. Submit the completed form with the federal tax return to the IRS.

Frequently Asked Questions

Can Section 1256 Losses Be Carried Back?

Yes, traders with a net loss from Section 1256 contracts can elect to carry back the loss up to three years to offset prior gains. This can result in a tax refund if the taxpayer had taxable Section 1256 gains in previous years.

Do All Futures and Options Qualify as Section 1256 Contracts?

No, only regulated futures contracts, foreign currency contracts, non-equity options and dealer contracts qualify as Section 1256 contracts. Stock options and equity-based derivatives do not receive the same tax treatment.

What Happens If I Do Not Report My Mark-to-Market Gains?

Failing to report mark-to-market gains or losses can result in IRS penalties, interest charges and an increased risk of an audit. Since all Section 1256 contracts are subject to annual mark-to-market accounting, accurate reporting is required even if the position is still open.

Bottom Line

Section 1256 contracts have special tax rules, including the 60/40 tax treatment and mark-to-market accounting, making them different from other investments. These contracts can offer tax benefits but require filing Form 6781 and reporting gains or losses yearly, even if trades are still open. Filing Form 6781 correctly is important to apply the right tax treatment. Investors with frequent trades may find it helpful to work with a tax consultant for accuracy.

Investment Planning Tips

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