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A 1256 Contract, as defined in section 1256 of the U.S. Internal Revenue Code, is 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. For U.S. Federal income tax purposes, mark-to-market accounting is used for each 1256 contract as of the end of each tax year, and such contracts are treated as dispositioned (i.e., as “closed”) at year end.
The Internal Revenue Service (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. Instead, the IRS grants penalty relief if a broker determines in good faith that an index is, or is not, a narrow-based index, following published guidelines.
Any gain or loss from a 1256 Contract is treated for tax purposes as 40% short-term gain and 60% long-term gain. Because most futures contracts are held for less than the 12-month minimum holding period for long-term capital gains tax rates, the gain from any non-1256 contract will typically be taxed at the higher short-term rate. Thus the 1256 Contract designation enhances the marketability based on the after-tax attractiveness of these products. The reason for the implementation of section 1256 was the fact that traders were hedging their short term futures contracts (going long and short at the same time) to transition to the next tax year without paying the short-term capital gains tax on these positions, and were effectively making these positions qualify for long-term tax treatment.
Section 1256 contract net losses can be carried back three years (instead of being carried forward to the following year), starting with the earliest 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), using Form 1045 or an amended return.
- “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.
- “These final regulations do not provide substantive rules on index options. Rather, to determine whether an index substantially all the components of which are specified securities is a broad-based index under section 1256(g)(6)(B), a broker must look to rules established by the Securities Exchange Commission and the Commodities Futures Trading Commission that determine which regulator has jurisdiction over an option on the index.” https://www.irs.gov/irb/2013-20_IRB/ar07.html
- “Synopsis: CFTC/SEC Agreement to Reform Shad-Johnson Accord”. CFTC.gov. Commodity Futures Trading Commission. Retrieved 2019-03-14.
- “Carryback of losses from section 1256 contracts to offset prior gains from such contracts”. 26 U.S. Code § 1212 – Capital loss carrybacks and carryovers. Legal Information Institute. Retrieved 16 April 2017.
- “Gains and Losses From Section 1256 Contracts and Straddles” (PDF). Form 6781. Internal Revenue Service. Retrieved 16 April 2017.
- “Form 1045, Application for Tentative Refund”. IRS.gov. Internal Revenue Service.