Section 1256 contracts and straddles are named for the section of the Internal Revenue Code that explains how investments like futures and options must be reported and taxed. Under the Code, Section 1256 investments are assigned a fair market value at the end of the year. If you have these types of investments, you'll report them to the IRS on Form 6781 every year, regardless of whether you actually sell them.
Section 1256 investments and straddles
Securities regarded as Section 1256 investments include:
- non-equity options
- foreign currency contracts
- regulated futures contracts
- dealer equity options
- dealer securities futures contracts
If you buy both a call option and a put option for the same investment security at the same time, your investment is known as a straddle. With a straddle, you typically only make money when there’s a significant price change in the underlying investment. One of the key characteristics of Section 1256 investments is that they use leverage, meaning that an investor only has to put up a small amount of money to control a larger valued investment.
For example, with a futures contract, an investor could control $100,000 of a commodity, such as silver, with only a $5,000 deposit, known as a margin deposit. For this reason, investments that fall under Section 1256 can result in huge gains or losses.
Gains and losses on Section 1256 investments and straddles
Under normal circumstances, if you buy a stock at $100 per share and hold it for 10 years, you don't have to report any gains or losses until you sell it. With Section 1256 investments, IRS requires you to report actual or would-be gains and losses through the end of the year on Form 6781. The basics of Section 1256 investments are as follows:
- You report gains and losses—as a result of an actual sale or the fair market value—through December 31 of each year.
- You complete Form 6781 even if you keep the investments.
- The process of assigning fair market value to investments you continue to hold, and don’t sell, is called “mark to market.”
- For tax purposes, every Section 1256 gain or loss is treated as being 60% long term and 40% short term, no matter how long you own it.
- Long-term gains, defined as those held for longer than one year, generally have more advantageous tax characteristics than short-term gains, which are held for one year or less.
Using Form 6781
Completing the form is similar to reporting any type of investment. Here’s the breakdown:
- Part I: Report your Section 1256 investment gains and losses at either the actual price at which you sold these investments or the "mark-to-market" price established on December 31.
- Part II: Report the gains and losses on your straddles, with losses reported in Section A and gains calculated in Section B.
- Part III: Meant for any unrecognized gains you have on positions held at the end of the tax year, but you only have to complete it if you have a recognized loss on a position.