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A 1256 Contract is a term used by the Internal Revenue Service to denote any regulated futures contracts, foreign currency contracts, non-equity options (broad-based stock index options (including cash-settled ones), debt options, commodity futures options, and currency options), dealer equity options, 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 QQQ, 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.
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 contracts 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 enhances the marketability based on the after-tax attractiveness of these products. The reason for the implementation of this tax code was due to the fact that traders were hedging their short term futures contracts (going long and short at the same time) in order to transition to the next tax year without paying the short-term capital gains tax on these positions and effectively making these positions qualify for long-term tax treatment.
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). In addition, futures based investments do not require the accounting of individual trades. This is a godsend for any of you who have spent hours searching through old brokerage statements from 4 years prior trying to find the cost basis for a certain stock. There is also no trade by trade accounting in futures, and no wash sale rules. Tax reporting for Section 1256 contracts is significantly simpler than for stocks, options, and single-stock-futures.
- "Section 1256 Contracts Marked to Market". Internal Revenue Service. Archived from the original on 20 May 2011. Retrieved 16 April 2011.
- "TITLE 26 > Subtitle A > CHAPTER 1 > Subchapter P > PART IV > § 1256". U.S. Code. Cornell University Law School, Legal Information Institute. Retrieved 16 April 2011.
- "Section 1256 Contract". Investopedia. Retrieved 16 April 2011.