Did you know that certain options have special tax treatment?
The IRS has favorable tax treatment for anything termed a “IRS Section 1256 Contract.” These are:
- Regulated futures contracts
- Foreign currency contracts
- Non-equity options (broad-based stock index options (including cash-settled)
- Debt options
- Commodity futures options
- Currency options
These contracts are “marked to market” at the end of the year and treated as if they were closed.
I primarily trade SPX index options. These qualify as Section 1256 contracts as they are broad-based stock index options. There are several tax benefits for trading these contracts.
Any gain or loss from a 1256 contract has a 60/40 tax treatment, regardless of the holding period! This means that 60% of the gain or loss is considered a long-term gain and 40% of the gain or loss is considered a short-term gain or loss. The Section 1256 rules apply even if you hold the position for seconds.
Section 1256 losses can be carried back three years but only to a year where there is a net Section 1256 gain and only to the extent of that gain.
Section 1256 contracts do not have to account for each trade. There is no trade by trade accounting and no wash sales rules. Tax reporting for Section 1256 is considerably simpler than it is for stocks, equity options and single-stock-futures.
Primary Tax Advantaged Index Options
Marty Kearny at the CBOE compiled this list years ago, but it should still be valid today:
- DJX – Dow Jones Industrial Average
- OEX – S&P 100 Index Options (American style)
- XEO – S&P 100 Index Options (European style)
- SPX – S&P 500 Index Options (My favorite)
- XSP – Mini-S&P 500 Index Options
- NDX – Nasdaq 100 Index Options
- RUT – Russell 2000 Index Options (very popular with Capital Discussions traders)
- Green Trader Tax – Accounting and tax preparation for traders
- SEC Definition of broad-based index
- IRS Resource Publication 550, Investment Income and Expenses
- IRS Form 6781 – Gains and Losses From Section 1256 Contracts and Straddles
- CBOE – Taxes & Investing document
- Motley Fool – Index Options Over ETFs?
- Twenty-First Securities Corporation – Exchange-Traded Index Options
Trading broad-based index options has advantages such as no earnings surprises, liquidity, extended trading hours and expirations and more. One of the best benefits that many don't consider is the favorable tax treatment where 60% of your gains or losses are treated as long-term gains or losses. This can lower your tax bill considerably.