1256 contract
Encyclopedia
A 1256 Contract is a term used by the Internal Revenue Service
to denote any regulated futures contract
s, foreign currency contracts, non-equity option
s (broad-based stock index options (including cash-settled ones), debt options, commodity futures options, and currency options), dealer equity option
s, dealer security futures contracts, and cash settled options (including euro-style index options). They are marked to market
at the end of the tax year and treated as dispositioned (i.e., "closed").
IRS is not clear on whether QQQQ, DIA and SPY options should be treated as section 1256 contracts. On one hand, these do not settle in cash (most Section 1256 contracts do), but on the other hand they meet the definition of a "broad-based" index option.
s are traded in a much shorter time frame than the 12 month rule required by the IRS for long term capital gains treatment, this creates an inherent tax disadvantage. Thus the 1256 Contract designation was created to enhance the after-tax attractiveness of these products.
Section 1256 contract net losses can be carried back 3 years (instead of being carried forward to the following year), but only to a year in which there is a net Section 1256 contracts gain, and only up to the extent of such gain (the carrying back cannot produce a net operating loss for the year). Tax reporting for Section 1256 contracts is significantly simpler than for stocks, options, and single-stock-futures.
Internal Revenue Service
The Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
to denote any regulated futures contract
Futures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s, foreign currency contracts, non-equity option
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
s (broad-based stock index options (including cash-settled ones), debt options, commodity futures options, and currency options), dealer equity option
Dealer equity option
A dealer equity option is any equity option listed on a qualified board of exchange, that is bought or granted by an options dealer . The dealer should be registered with the qualified board of exchange where the option is listed.Under U.S...
s, dealer security futures contracts, and cash settled options (including euro-style index options). They are marked to market
Mark to market
Mark-to-market or fair value accounting refers to accounting for the fair value of an asset or liability based on the current market price of the asset or liability, or for similar assets and liabilities, or based on another objectively assessed "fair" value...
at the end of the tax year and treated as dispositioned (i.e., "closed").
IRS is not clear on whether QQQQ, DIA and SPY options should be treated as section 1256 contracts. On one hand, these do not settle in cash (most Section 1256 contracts do), but on the other hand they meet the definition of a "broad-based" index option.
Tax advantages
Any gain or loss from a 1256 Contract is treated for tax purposes as 40% short-term gain and 60% long-term gain. Typically the gain from any non-1256 contract will be taxed 100% at the short-term rate because the position is usually held for less than 12 months. Since most futures contractFutures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
s are traded in a much shorter time frame than the 12 month rule required by the IRS for long term capital gains treatment, this creates an inherent tax disadvantage. Thus the 1256 Contract designation was created to enhance the after-tax attractiveness of these products.
Section 1256 contract net losses can be carried back 3 years (instead of being carried forward to the following year), but only to a year in which there is a net Section 1256 contracts gain, and only up to the extent of such gain (the carrying back cannot produce a net operating loss for the year). Tax reporting for Section 1256 contracts is significantly simpler than for stocks, options, and single-stock-futures.