Tax Treatment of Section 1256 Contracts

Section 1256 of the Internal Revenue Code provides special tax treatment for regulated futures contracts, foreign currency contracts, and certain options. The 60/40 rule—60% long-term, 40% short-term capital gains regardless of holding period—offers significant tax advantages for active futures traders.

Definition and Key Concepts

What Are Section 1256 Contracts?

Section 1256 contracts include:

• Regulated futures contracts (traded on U.S. exchanges)
• Foreign currency contracts (certain interbank forward contracts)
• Non-equity options (options on broad-based indices, futures)
• Dealer equity options
• Dealer securities futures contracts

Not included:

• Equity options on individual stocks
• Securities (stocks, bonds)
• Cryptocurrency (in most cases)
• Foreign futures not regulated by CFTC

The 60/40 Rule

Section 1256 gains and losses are treated as:

• 60% long-term capital gain/loss (taxed at preferential rates)
• 40% short-term capital gain/loss (taxed at ordinary rates)

This applies regardless of how long you held the position.

Tax Rate Comparison

Blended rate calculation (Section 1256): 60% × 20% (LTCG max) + 40% × 37% (STCG max) = 12% + 14.8% = 26.8% max

Compared to 37% for short-term gains, Section 1256 offers up to 10+ percentage points savings.

Mark-to-Market Requirement

Section 1256 contracts are marked to market on December 31:

• Open positions treated as if sold at year-end price
• Gain or loss recognized even without actual sale
• Basis in position adjusted for next year

This prevents deferring gains by holding positions over year-end.

How It Works in Practice

Annual Tax Reporting

Year 1: Open Position at Year-End

Tax treatment:

• 60% LTCG: $30,000 × 20% = $6,000
• 40% STCG: $20,000 × 37% = $7,400
• Total tax: $13,400 (26.8% effective rate)

Year 2: Close Position

The Year 2 loss offsets other Section 1256 gains, or up to $3,000 of ordinary income, with carryforward.

Form 6781 Reporting

Section 1256 gains and losses are reported on Form 6781:

These amounts flow to Schedule D.

Loss Carryback Provision

Section 1256 losses can be carried back 3 years to offset prior Section 1256 gains:

Year 1: $100,000 Section 1256 gain (tax paid: $26,800) Year 4: $150,000 Section 1256 loss

Carryback option: Carry $100,000 of Year 4 loss back to Year 1, amending return and recovering $26,800. Remaining $50,000 loss carries forward.

This is more favorable than the standard capital loss treatment (no carryback, $3,000/year ordinary income offset).

Worked Example

Annual Tax Comparison: Futures vs. Stocks

A trader generates $100,000 profit with average holding period of 2 months.

Scenario A: Stock Trading (Non-Section 1256)

All gains are short-term capital gains: Tax: $100,000 × 37% = $37,000

Scenario B: Futures Trading (Section 1256)

60/40 treatment applies:

• LTCG: $60,000 × 20% = $12,000
• STCG: $40,000 × 37% = $14,800
• Total: $26,800

Tax savings: $37,000 - $26,800 = $10,200 (27.6% lower)

Multi-Year Example

Year 1: +$80,000 Section 1256 gain Year 2: +$120,000 Section 1256 gain Year 3: -$150,000 Section 1256 loss

Without carryback: Year 1 tax: $21,440 Year 2 tax: $32,160 Year 3: Loss carryforward of $147,000 ($150,000 - $3,000 ordinary offset)

With carryback: Apply $80,000 to Year 1 → refund $21,440 Apply $70,000 to Year 2 → refund $18,760 Remaining $0 loss Total refund: $40,200

The carryback recovers taxes paid in profitable years, providing immediate relief.

Straddle Rules Interaction

Section 1256 contracts may be subject to straddle rules (Section 1092) when combined with other positions:

Example: Long stock + short futures on same index

The IRS may:

• Defer loss recognition on one leg
• Adjust holding period calculations
• Require identification of offsetting positions

Consult a tax professional when combining Section 1256 contracts with equity positions.

Risks, Limitations, and Tradeoffs

Year-End Tax on Unrealized Gains

Mark-to-market creates tax liability on paper profits:

• Position may reverse in January, but December 31 gain is taxed
• Cash flow mismatch: Tax due April 15, P/L may change after year-end
• Requires tax planning for large open positions

Loss Limitations

While carryback is available, losses still have limitations:

• Only offset Section 1256 gains in carryback years
• Excess becomes capital loss (subject to $3,000/year limit vs. ordinary income)
• Wash sale rules don't typically apply, but straddle rules may

Not All Futures Qualify

Some instruments don't receive Section 1256 treatment:

• Cryptocurrency futures (treatment uncertain/varies)
• Foreign futures not under CFTC regulation
• Equity options on individual stocks
• Securities futures contracts (different rules)

Verify each product's classification.

State Tax Treatment

States may not follow federal 60/40 treatment:

• Some states tax all gains as ordinary income
• State carryback rules may differ
• Calculate state and federal separately

Common Pitfalls

1. Assuming all futures qualify: Verify Section 1256 status for each contract traded.

2. Ignoring year-end mark-to-market: Plan for tax liability on December 31 values.

3. Forgetting carryback elections: Must file amended returns to carry back losses.

4. Mixing with securities positions: Straddle rules complicate treatment of combined positions.

5. State tax surprises: Some states don't recognize 60/40 treatment.

Checklist for Section 1256 Reporting

• Verify traded contracts qualify as Section 1256
• Calculate year-end mark-to-market gain/loss
• Aggregate all Section 1256 activity across accounts
• Complete Form 6781 with 60/40 split
• Transfer amounts to Schedule D
• Evaluate loss carryback opportunity if applicable
• File amended returns (Form 1040-X) for carrybacks
• Consider straddle rule implications for hedged positions
• Calculate state tax separately if treatment differs
• Maintain records of all positions and settlements

Next Steps

For a comprehensive glossary of futures terminology, see Glossary: Futures Market Terms.

To understand systematic trading approaches, review Backtesting Futures Trading Systems.