Tax Considerations: Section 1256 Contracts Revisited

By Lawrence G. McMillan

We usually try to run an article on this subject at least once during tax season. I realize that not everyone is aware of the rules governing Section 1256 contracts. Hence, since tax season is upon us, I thought this review might be of benefit to some of our subscribers – and to options and futures traders, in general.

Section 1256 trades include all futures trades, as well as futures options. They also include option trades on cash-based indices ($OEX and $SPX, and especially $VIX), but not SPY or QQQ, for example, for the underlying there is an ETF, not cash.

A Section 1256 trade is treated as 60% long-term and 40% short-term, no matter if the position was held for one minute or one year. Also, each Section 1256 contract held at the end of the year should be marked to market at year-end, and the resulting gain or loss reported as a gain or loss for that year.

These should be itemized separately and reported on your Schedule D as one line in the short-term section and one line in the long-term section. Hence, one needs to keep track of this unrealized portion from year to year, as it needs to be reversed out the next year.

For subscribers of this newsletter, some of our trades fall into the Section 1256 category – notably the put ratio spreads using S&P or e-mini futures and some of the $VIX/SPY hedges (the $VIX portion, but not the SPY portion, would be a Section 1256 transaction).

Since those traders who used the S&P futures for the put ratio spreads instead of the SPY puts would receive this favorable capital gains tax treatment, that is another reason to favor the S&P put ratio spread over the SPY put ratio spreads.

Outside of the $VIX trades, I don’t think we recommended many, if any trades, in cash-based index options last year, but we did have quite a few futures trades.

You should consult your tax advisor about this subject, for there are some interpretations as to what may or may not qualify as a Section 1256 contract. The actual legal language contains the term “non-equity” option, which is open to some interpretation.

Originally published in The Option Strategist Newsletter Volume 24, No. 4. Introductory 3 month trial subscriptions are available for only $29.