Futures trading involves risks that can result in losses. Unless you make your living as a futures trader, the Internal Revenue Service considers you an “investor” and instructs you to treat your losses as capital losses. Futures investors and traders can choose a special tax treatment called “mixed straddle election” to simplify their tax reporting and lower their taxes due. The IRS considers you a “trader” if you meet certain criteria. Traders have the option to treat losses as ordinary.
Capital Losses vs. Ordinary Losses
A capital loss occurs when you sell something of value for less than its purchase price. You use capital losses to offset capital gains, thereby reducing you tax obligation. Long-term capital losses, arising from investments you hold for over a year, are first applied to long-term capital gains and then to short-term gains. Short-term capital losses are first applied to short-term gains and then long-term ones. You can deduct any excess capital losses against $3,000 of ordinary income per year. You may carry forward any unused short and long capital losses to future years. You can deduct ordinary losses up to your full income amount and carry any excess ordinary losses forward.
Mixed Straddle Election
Futures investors and traders can make a mixed straddle election when they file income tax, enabling them to automatically classify their net capital gains on futures as 60 percent long-term and 40 percent short-term. Net capital gains are your trading gains minus losses. The 60/40 rule removes your requirement to keep exact records on each trade beyond the gain or loss. Long-term capital gains are subject to favorable tax rates of 20, 15 or zero percent, depending on your modified adjusted gross income.
Qualifying as a Futures Trader
To qualify as a trader, IRS Publication 550 requires that: “You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation; your activity must be substantial; and you must carry on the activity with continuity and regularity.” The IRS considers several factors to confirm you are a futures trader rather than an investor, including how long you hold the securities, your trade frequency and the time you spend trading as opposed to time spent on some other income-producing activity.
Qualifying for Ordinary Losses
As a futures trader seeking to qualify for ordinary losses, you must inform the IRS that you elect the “mark-to-market” method to report your trading income. This election requires you to report your year-end futures holdings as if you sold and repurchased them on the last trading day of the year. This forces you to realize a trade’s gain or loss in the same tax year that you make the trade. Under mark-to-market rules, you report your losses as ordinary on Schedule C, Profit or Loss From Business. Your commission costs are not deductible, but you use them to figure the amount of gain or loss. Traders do not have to pay self-employment tax on their trading income.
- The Futures Game: Who Wins, Who Loses, & Why; Richard Teweles, Frank Jones
- The Tax Guide for Traders; Robert Green
- Trading Futures for Dummies; Joe Duarte
- Comstock/Comstock/Getty Images