7585 / How are spread transactions taxed?

Generally, positions are offsetting if the taxpayer substantially reduces the risk of holding one position with respect to personal property while at the same time holding another position with respect to personal property, whether or not it is of the same type.² See Q 7593 for an explanation of the IRC definition of “offsetting” and Q 7599 for an explanation of the treatment of tax straddles.

The Tax Court has taken the position that spread transactions are not “similar arrangements” within the meaning of IRC Section 465(b)(4), and that losses on stock option spreads are thus not limited by the “at risk” rules.³ However, the IRS, issuing a very limited partial acquiescence to the Tax Court’s Laureys decision, noted its nonacquiescence as to whether offsetting positions in stock options are subject to the limitations of IRC Section 465(b)(4). See Q 8004 and Q 8005 for an explanation of the “at risk” rules.

To the extent that one position of a spread is offset by only a portion of the other position, only those portions of the spread that offset one another will be treated as offsetting (and subject to the tax straddle rules) unless the position is part of a larger tax straddle.⁴ Apparently, any options positions that are not offset by other positions will be taxed under the general rules governing equity options (see Q 7560 to Q 7581).

Positions consisting entirely of options that are IRC Section 1256 contracts (i.e., dealer equity options and nonequity options) are exempt from the tax straddle rules and, instead, taxed under the mark-to-market rules in IRC Section 1256. Such positions will not constitute an “appreciated financial position” (see Q 7617), but may constitute a constructive sale of another position (see Q 7618). See Q 7592 for an explanation of IRC Section 1256 treatment. Spreads consisting of at least one, but not all, IRC Section 1256 contracts are subject to the rules for “mixed straddles.” For an explanation, see Q 7605.

Aside from the special rules for IRC Section 1256 contracts (see above), it is clear that certain combinations of options (to be specified in future regulations) or options held contemporaneously with offsetting positions that have the effect of reducing both the taxpayer’s risk of loss and opportunity for gain, will trigger constructive sales treatment under IRC Section 1259, unless certain exceptions apply (see Q 7617 to Q 7621).⁵

A spread transaction that is a straddle under IRC Section 1092(c) may also constitute a conversion transaction. See Q 7615 and Q 7616 for the definition and tax treatment of conversion transactions.