7592 / How are regulated futures contracts and other Section 1256 contracts taxed?

Regulated futures contracts and IRC Section 1256 contracts, like other positions that are subject to the mark-to-market requirements, are excluded from the definition of an appreciated financial position under IRC Section 1259(b)(2)(B) (see Q 7617). However, depending on the taxpayer’s other holdings, it appears that a constructive sale could result from the taxpayer’s entering into a regulated futures contract (or another IRC Section 1256 contract) to deliver property that is the same as or substantially identical to an appreciated financial position held by the taxpayer³ (see Q 7617 to Q 7621).

The owner of a regulated futures contract that is part of a tax straddle or a conversion transaction may be subject to different tax rules (see Q 7593 to Q 7616).⁴

Gains and losses on IRC Section 1256 contracts held for investment are capital gains and losses regardless of the nature of the underlying property.⁵

IRC Section 1256 contracts – other than those subject to the special rules for tax straddles (see Q 7604) – must be “marked to the market.” Under the mark-to-market tax rules, gains and losses inherent in IRC Section 1256 contracts owned by an investor at the end of the year or at any time during the year must be reported annually, even if those gains or losses have not been realized by the investor. To accomplish this, any IRC Section 1256 contract that has not been terminated or transferred before the end of the tax year is treated as if it were sold for its fair market value on the last business day of that year.⁶ Any gain or loss on such a “deemed” sale must be reported and gain taxed as discussed below. Any IRC Section 1256 contract terminated or transferred during the year is deemed to have been sold for its fair market value on the date it was terminated or transferred. (Termination or transfer may include offset, taking or making delivery, exercise, assignment, lapse, or any other transaction that terminates or transfers the taxpayer’s rights or obligations under the contract.)⁷ If the IRC Section 1256 contract was closed out during the year in an arm’s-length transaction, its fair market value is considered to be the actual price paid or received in the closing transaction, and the amount of gain or loss required to be reported equals the amount actually realized. In all other cases, including where the IRC Section 1256 contract remains open at year-end, fair market value is ordinarily the settlement price on the exchange as of the appropriate date.⁸

Any gain or loss required to be reported by an investor on an IRC Section 1256 contract under the mark-to-market rules is treated as if 40 percent of the gain or loss is short-term capital gain or loss and 60 percent is long-term capital gain or loss.⁹ The usual holding period rule for determining whether a gain or loss is short-term or long-term is ignored.¹⁰ For the taxation of capital gains and losses, see Q 702.

IRC Section 1091 (relating to losses from wash sales of stock and securities) does not apply to any loss taken into account under the general rule governing losses for Section 1256 contracts.¹¹

The mark-to-market tax rules do not apply to hedging transactions entered into as part of the taxpayer’s trade or business.¹² According to the 1997 Blue Book,¹³ it was the intent of Congress that the constructive sale provisions (see Q 7617 to Q 7621) would apply to such transactions.

An investor who has a “net IRC Section 1256 contracts loss” for a year may elect to carry such loss back three years and then, to the extent not depleted, carry it forward to succeeding years under the rules provided in IRC Section 1212(c). A United States District Court determined that IRC Section 1256 contract losses could be carried back to offset gains in a previous year even though the losses were attributable in part to contracts subject to a mixed straddle account election (see Q 7607).¹⁴

If an investor reports gain or loss on an IRC Section 1256 contract that was taxed to him or her in a prior year under the mark-to-market rules, that gain or loss is adjusted to reflect the gain or loss reported in that prior year (or years).¹⁵