A futures option provides the holder the right, but not requirement, to buy (with a call) or sell (with a put) a specified futures contract on or before the option expiration date. The option’s price is termed the premium. Gains and losses from futures options are reported as capital gains/losses. If positions are held for a year or longer, they are long-term capital gains and taxed at a special lower rate. Short-term capital gains rates (which are the same as the tax rates on normal income) apply to holdings of less than a year. The IRS, under special circumstances, may allow you to designate a part of your short-term capital gains/losses as long-term.
You can use IRS Form 6781 to report any market-to-market capital gains and losses that may have occurred as part of a 1256 contract.
Simplified Reporting for Type 1256 Contracts
Section 1256 of the IRS regulations provides for simplified reporting of gains/losses on particular contract types, such as futures options. To take advantage of this section, you must mark-to-market any open 1256-type contracts at year’s end. This has the effect of affixing the current price to the contract and then closing and reopening the contract at that price. The outcome is the same as if you had sold and repurchased the contract on the last trading day of the year.
Tax Considerations for Type 1256 Contracts
Once you have established your capital gain/loss from marking your 1256-type contract to market, you can then apply the special tax classifications granted by the IRS. This allows you to arbitrarily declare 60 percent of capital gains/losses as long-term, and the remainder as short-term. Because long-term capital gains rates are lower than short-term rates, this rule provides a tax break to 60 percent of your unrealized gains and losses. The carry rules of Section 1256 allow you to carryback losses up to three prior years and/or carry forward losses one year. The 60/40 rule has remained intact with the Tax Cuts and Jobs Act of 2018.
Applying Carryback Losses
Carryback losses allow you to restate prior-year gains by retroactively applying the loss starting with the third previous year. The effect is to reduce the taxes previously paid on the gains. The amount of loss applied in any one prior year is capped by the amount of gain for the year – you will not be allowed to establish an overall loss due to carrybacks. If the carryback amount is not fully absorbed in the third prior year, you can continue to apply the amount to the following two years. The 60/40 long-term/short-term capital gain split applies to each of the carryback years.
How to Apply Carryforwards
If, after applying three years’ worth of carrybacks, you still have an unabsorbed capital loss, you can carry it forward to the next tax year. These carryforwards are also subject to the 60/40 split. Note that Section 1256 cannot be utilized for contracts that hedged other positions. Hedging is a process in which one position offsets another. An example of a hedge would be a long (purchased) position in a futures contract and a simultaneous short (sold) position in an option on the futures contract.
Tax Filing for 1256 Contracts
Fill out IRS Form 6781 to report your marked-to-market capital gains/losses from 1256 contracts that were open at year’s end, You use the same form to report contracts closed during the year. The information you need for this form is supplied to you from your broker on Form 1099-B. The net amount from Form 6781 must then be transferred to Form 1040 Schedule D. If you are due to receive a refund due to a carryback restatement, you will need to fill out Form 1045 and include with it revised versions of Schedule D and Form 6781 for each carryback year.