Naturally, many people start their quest in becoming traders with stock trading, as stocks are the cornerstone of the financial markets. As the quest continues, many realize the great benefits of trading futures, or as the code defines those, 1256 contracts.
For U.S. federal tax purposes, regulated futures contracts, such as the E-mini S&P 500 futures, are classified as being IRC Section 1256 contracts and are taxed differently than securities (stocks). In general, the net gain from trading commodities is taxed 60 percent at long-term capital gains tax rates and 40 percent at short-term capital gains tax rates. Currently, the maximum long-term capital gains tax rate is 15 percent and the maximum short-term capital gains tax rate (ordinary rate) is 35 percent, therefore, the net maximum of 60/40 blended tax rate = 23 percent. This reduced tax rate works to the advantage of the profitable E-mini day trader.
Preferred tax rate. Securities are usually taxed at short-term capital gains rates for traders because they normally hold positions for less than a year. Thus, most securities traders pay substantially higher income tax rates than futures traders. It is important to understand that the time you hold the futures contract is not relevant to the preferential treatment of the 60/40 split. The 60/40 split is automatic to any regulated futures trade. Let me give an example using 2011 tax rules. Joe, the “commodities futures” trader, is married filing jointly. He makes $75,000.00 trading gold futures on the CME. This activity falls under section 1256 contracts. His tax liability would be $1,103. If Joe made the same $75,000.00 in profit trading single stock futures or futures on indexes, the entire amount is short-term capital gains and taxed at his personal income tax rate. His tax liability would be $7,754. The difference between short-term capital gains and section 1256 contracts is $6,651.00 in tax savings!
Mark-to-Market treatment. Futures traders also benefit from a built-in mark-to-market accounting. Section 1256 contracts are marked to market at the end of each tax year. No election needs to be made. Consequently, all traders and investors report realized and un-realized gains and losses. This also means that if you are trading futures, you will not need to worry about wash sale rules as they do not apply to futures.
Do not confuse section 1256 mark-to-market accounting with IRC 475 (f) election to use MTM. MTM (IRC 475) is generally not the preferred method for profitable commodities and futures traders as it will increase their taxes on gains and only marginally improve their ability to carry back losses.
Ease of filing. Another great benefit is that year-end tax reporting generally does not require a detailed listing of each trade, as is required for securities traders. This can save you time when filling out your return and cost when using a professional accountant. Regardless of the fact that most futures trading is exempt from detailed transaction reporting, traders must keep the detailed records in their files as any well-run business would maintain its records. If you are audited, these details will be used to substantiate the volume of your daily activity in support of claiming “trader status” on your tax return.
Three year carry back of losses from section 1256 contracts. An individual or partnership having a net section 1256 contracts loss can elect under §1212(c) to carry this loss back 3 years, instead of carrying it over to the next year. The loss carried back to any year under this election cannot be more than the net section 1256 contracts gain in that year. In addition, the amount of loss carried back to an earlier tax year cannot increase or produce a net operating loss for that year. The loss is carried to the earliest carry back year first, and any unabsorbed loss amount can then be carried to each of the next 2 tax years. If only a portion of the net section 1256 contracts loss is absorbed by carrying the loss back, the unabsorbed portion can be carried forward, under the capital loss carryover rules, to the year following the loss.
If you experienced losses in futures trading in 2011 and have futures gain in prior years, you need to contact one of our professional accountants as you will need to file Form 1040X or Form 1045, Application for Tentative Refund, for the year to which you are carrying the loss. This could mean a savings of thousands of dollars to you.
Last Word. Trading futures offers many advantages such as leverage, 24 hour trading opportunities, favorable 60/40 split on your tax liability, ease of tax filing and the ability to carry back your losses. If you have not traded futures yet, you may want to consider it. You may find that once you trade futures, they become your favorite trading vehicle.
Be sure to visit our OTA Tax Pros website to find out how you can attend a free tax planning webinar.
– Michael Atias