Futures traders qualify for certain tax breaks that simplify record-keeping and save money. The rules revolve around Section 1256 contracts as defined by the Internal Revenue Service. To qualify, a futures contract must be traded on an exchange approved by the Commodity Futures Trading Commission and must undergo daily settlement procedures called "marking to market." Capital gains and losses on qualifying futures are automatically set at 60 percent long-term and 40 percent short-term.
Marking to Market
A futures contract is settled daily via marking to market. Every futures contract has a buyer and a seller. If prices go up for the day, the contract buyer registers a gain. Lower prices benefit contract sellers. At a predetermined time every day, exchanges such as the Chicago Mercantile Exchange close for half an hour to apportion the day’s gains and losses to traders’ brokerage accounts. Should an account balance fall below the required minimum, additional cash will be requested via a margin call. Failure to meet a margin call will cause a broker to liquidate contracts.
Capital Gains and Losses
Futures contracts do not pay dividends or interest, so the only source of income from them is a price change. The Internal Revenue Service uses a special 60/40 long-term/short-term "mixed straddle" rule for taxing income from futures trading. Although long-term capital gains are usually associated with holding periods of a year or more, the mixed straddle rule automatically splits futures gains as 60 percent long-term and 40 percent short-term, notwithstanding the actual contract holding periods. Long-term capital gains are taxed at a maximum of 15 percent, but short-term capital gains are taxed as normal income. Losses can be used to offset gains. If you have more losses than gains, you can carry back your losses up to three years by using them to offset gains in previous tax years. You must refile your returns for retroactively applied losses. You also can carry excess losses forward one year if you exhaust your useful carryback offsets.
Gains and losses on securities such stocks and bonds remain unrealized, and thus untaxed, until the positions are sold. The taxpayer can decide when to trigger a tax event by timing the sale of a security. The IRS treats futures contracts differently. Capital gains and losses must be recognized Dec. 31, even if the contract remains open into the new year. From a tax viewpoint, it is as if you closed the contract on the last day of the year and reopened it the next day.
Many traders with net profits from futures contracts minimize their taxes for the current year by closing losing non-futures positions before the end of the year. The capital losses thus realized are then used to offset any gains generated by the year-end reset of futures contracts. Traders have the option to immediately reopen the closed positions; the net effect is simply to realize losses in the current year. Losses in excess of gains are deductible in any one year up to a limit of $3,000. Excess capital losses can be used to reduce taxes in past or forward years as described earlier.
- Federal Income Tax: Code and Regulations -- Selected Sections (2011-2012); Martin B. Dickinson
- The Tax Guide for Traders; Robert A. Green
- The 5 Fundamentals of Building a Retirement Portfolio; The Financial Lexicon
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