Can Section 1256 Losses Offset Schedule D Capital Gains?

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In the United States, Section 1256 securities relate to regulated futures contracts, foreign currency contracts, non-equity options, dealer security options, and dealer securities futures contracts. The Internal Revenue Code requires these contracts to be reported annually on Form 6781. Losses or gains from Section 1256 securities are first to offset any capital gains or losses reported on Schedule D of Form 1040, U.S. Individual Income Tax Return.


Prior to 1981, the U.S. Internal Revenue Code allowed disparate treatment of many futures and derivative contracts, depending upon how the contracts were disposed. Contracts that were traded or assigned to a third party were eligible for capital gains treatment. Contracts that were offset by acquiring an opposite position were considered extinguished and were treated as ordinary income. Since capital gains rates were significantly less than ordinary income rates, traders of these securities began to trade or assign all contracts with gains and extinguish all contracts with losses, thereby claiming lower-rate long-term capital gains rates on all income.


To resolve this perceived abuse, Congress passed Section 1256 of the Internal Revenue Code through the Economic Recovery Tax Act of 1981 and later amended it through the Technical Corrections Act of 1982. These acts mandated that all eligible futures and derivatives contracts (regulated futures contracts, foreign currency contracts, non-equity options, dealer security options, and dealer securities futures contracts) would be reported at market value annually, and gains or losses would be taxed at 60 percent long-term capital gain rates and 40 percent short-term capital gain rates.


The Internal Revenue Service (IRS) requires that taxpayers report all Section 1256 securities on Form 6781, Gains and Losses From Section 1256 Contracts and Straddles. The net long-term gains or losses on Form 6781 are then transferred to Schedule D, Capital Gains or Losses, of Form 1040 where they are added to or used to offset all other net long-term gains or losses of the taxpayer. Likewise, net short-term gains or losses on Form 6781 are transferred to Schedule D and added to or used to offset all other net short-term gains or losses of the taxpayer.


This treatment of offsetting Section 1256 gains or losses against other capital gain or loss income on Schedule D can be problematic for taxpayers not classified as traders when net losses are generated. (Taxpayers are typically classified as traders when their primary business activity involves the trading or dealing of securities.) For non-traders, net capital gain losses may only be offset against ordinary income for amounts up to $3,000 annually. Thus, an investor with significant Section 1256 losses may not be able to immediately recognize a tax benefit from the losses.

Mark to Market Treatment

A very important characteristic of the tax treatment of Section 1256 securities is that they must be marked to market at the end of every tax year. Mark to market treatment involves treating the security as if it were sold on the last day of the year for the fair market value (FMV) on that date. The gain or loss on the security is thus computed based on the FMV, which subsequently becomes the basis value for the subsequent tax year.

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