1256 Contract


A 1256 Contract, as defined in section 1256 of the U.S. Internal Revenue Code, is any regulated futures contracts, foreign currency contracts, non-equity options, dealer equity options, dealer security futures contracts. For U.S. Federal income tax purposes, mark-to-market accounting is used for each 1256 contract as of the end of each tax year, and such contracts are treated as dispositioned at year end.
The Internal Revenue Service is not clear on whether QQQ, DIA and SPY options should be treated as section 1256 contracts. On one hand, these do not settle in cash, but on the other hand they meet the definition of a "broad-based" index option. Instead, the IRS grants penalty relief if a broker determines in good faith that an index is, or is not, a narrow-based index, following published guidelines.

Tax advantages

Any gain or loss from a 1256 Contract is treated for tax purposes as 40% short-term gain and 60% long-term gain. Because most futures contracts are held for less than the 12-month minimum holding period for long-term capital gains tax rates, the gain from any non-1256 contract will typically be taxed at the higher short-term rate. Thus the 1256 Contract designation enhances the marketability based on the after-tax attractiveness of these products. The reason for the implementation of section 1256 was the fact that traders were hedging their short term futures contracts to transition to the next tax year without paying the short-term capital gains tax on these positions, and were effectively making these positions qualify for long-term tax treatment.
Section 1256 contract net losses can be carried back three years, starting with the earliest year, but only to a year in which there is a net Section 1256 contracts gain, and only up to the extent of such gain, using Form 1045 or an amended return.