Futures and Cash-Based Options: Section 1256 Tax Considerations

By Lawrence G. McMillan

Futures traders and traders of cash-based options have a tax advantage:  on every trade, no matter how long the position is held, the results are considered 60% long-term gain and 40% short-term gain.  These are called Section 1256 trades.

This tax treatment grew out of the 1986 Tax Reform Act, and it represents a possible boon to traders who have profits in those areas (futures or cash-based options).

Cash-based options are those that are not exercisable into stock or an ETF, but rather are settled for cash if they are held until expiration.  This includes most index options, including $VIX options.

Other cash-based options would include things like $SPX options, $RUT options (the Russell 2000 Index), $NDX options, etc.

But this tax treatment does not extend to ETF’s on those products.  Hence, SPY, IWM, or QQQ options would not be treated as Section 1256 trades.  They would be “regular” short-term gains or losses unless held for more than a year.

If you do have Section 1256 trades, be sure to account for them properly, or tell your accountant to do so. He might not readily be looking for this type of activity in your account, unless you inform him.■