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Commodities and Section 1256 Contracts

Commodities are taxed differently than securities. For commodity tax law, you need to learn about IRC Section 1256 contracts, Form 6781, special Form 6781 carry backs and IRC Section 988 (for currency traders only).

Commodities traders may also qualify for "trader tax status" (business treatment) and elect IRC 475 – mark-to-market accounting.

Is it a security or a commodity?:

The universe of trading instruments is growing every day, providing traders with many new opportunities for profits. Tax-wise, the IRS forces all these instruments into two main tax categories: "securities" or "commodities." Figuring out how to treat all the new products is a challenge.

For securities, business traders report capital gains and losses on Schedule D (default cash method) or ordinary gains and losses on Form 4797 Part II (if mark-to-market accounting IRC 475 is elected). Securities traders rarely hold positions for more than 12 months, so the bulk of their trading gains are short-term capital gains subject to the ordinary income tax rates.

For more information about the tax advantages of commodities over securities, including tax changes in the 2003 Tax Act, see the article by our Robert A. Green, CPA, in the August 2003 issue of Active Trader magazine: "What's the Difference? Besides stocks, traders have a wide range of financial products to trade. In the eyes of the IRS, though, all these products fall into one of two categories: securities or commodities. Why you may think the difference is inconsequential, products classified as commodities have tax benefits securities do not have." The article content is also available on our site. Click here.

Tax rates on commodities vs. securities, pre- and post-2003 Tax Act:

Commodities are section 1256 contracts taxed 60 percent at long-term capital gains tax rates and 40 percent at short-term capital gains tax rates (i.e., ordinary income tax rates).

Pre-2003 Tax Act:
60 percent multiplied by maximum long-term capital gains tax rate of 20 percent = 12 percent.
40 percent multiplied by maximum short-term capital gains tax rate (ordinary rate) of 38.6 percent = 15.44 percent.
Net 60/40 blended tax rate = 27.44 percent.

Post-2003 Tax Act: (the 60/40 split survived a last-minute attack from the Senate)
60 percent multiplied by maximum long-term capital gains tax rate of 15percent = 9 percent.
40 percent multiplied by maximum short-term capital gains tax rate (ordinary rate) of 35 percent = 14 percent.
Net 60/40 blended tax rate = 23 percent.

The 2003 Tax Act provides a rate reduction for commodities traders of 4.44 percent.

Securities are usually all short-term for traders, because they hold positions for less than 12 months.

Pre-2003 Tax Act:
Maximum short-term capital gains tax rate (ordinary rate) of 38.6 percent.

Post-2003 Tax Act:
Maximum short-term capital gains tax rate (ordinary rate) of 35 percent.

The 2003 Tax Act provides a rate reduction for securities traders of 3.6 percent (for short-term tax rates).
For investors, long-term capital gains tax rates were reduced by 5 percent or more.

Notice that the reductions for securities traders (3.6 percent), commodities traders/investors (4.44 percent) and securities long-term investors (5 percent) are similar. It is important to note the net tax rates, which are significantly better for commodities traders vs. securities traders (23 percent vs. 35 percent, respectively).

Effective dates: The ordinary income tax rate reduction changes are effective Jan. 1, 2003. The long-term capital gains rate reduction changes are effective for sales and exchanges after May 5, 2003. For more information about the new tax laws, click here.

Regulated Futures Contracts (RFC): IRC Section 1256 Contracts:

"Regulated futures contracts" (RFC) are traded on commodities exchanges and as the "regulated" label suggests, these RFCs are regulated by the exchange and the CFTC.

Exchange traded commodities, including "currency RFCs" are covered under IRC section 1256 contracts. Business traders and all investors report RFC section 1256 contracts as capital gains and losses on Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles). This allows them to split the gains and losses 60/40 on Schedule D: 60 percent long-term, 40 percent short-term.

This 60/40 split gives commodities traders and investors an advantage over securities traders. For this reason, most profitable commodities business traders don’t elect MTM IRC 475. With 475, commodities trader can have “tax-loss” insurance (ordinary loss treatment), but they are reluctant to give up their beneficial tax rates on gains (the 60/40 split).

Section 1256 Contracts:
Section 1256 contracts include: regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer securities futures contracts. For a partnership that's a qualified fund, Section 1256 contracts include bank forward contracts, foreign currency futures contracts, and similar instruments prescribed by IRS regs.

Commodities are IRC §1256 contracts. Section 1256 contracts are marked-to-market at the end of each tax year, so all traders and investors report realized and unrealized gains and losses. There is no election here.

Do not confuse Section 1256 mark-to-market accounting with the new trader tax laws, IRC Section 475(f): A qualified commodities trader (one who has trader tax status) may elect IRC 475(f)(2), the new mark-to-market tax laws. The effect of this election is to convert Section 1256 contracts with capital gain or loss treatment (60/40 split) into "ordinary gains and losses" reported on Form 4797 (Sale of Business Property).

We do not recommend IRC 475(f)(2) elections for commodities traders: Profitable commodities traders would lose the long-term capital gains rate tax advantage mentioned above. If you lose significant money trading commodities before April 15, 2002, and wish to exit the business, then elect IRC 475(f)(2) in order to receive ordinary loss treatment. You will need it.

Net Section 1256 Contracts Loss Election: In the Form 6781 instructions, see the directive for Box D (Net Section 1256 Contracts Loss Election). When preparing Form 6781, all individual taxpayers may mark Box D, thereby electing to carry back a net section 1256 contract loss three tax years. You then file an amended return for the carryback year and you may apply the section 1256 carryback loss on your Form 6781 for that prior tax year. Note: If you don't have Form 6781 gains in that prior carry back year, you won't get any benefit from this carry back. So check this before you make this election. Unlike IRC 475(f)(2), you can make this section 1256 carry back election when you prepare your 2001 tax return.

What is and is not a Section 1256 Contract: See the area titled “Definitions” in IRC §1256 law. There is great confusion among trader taxpayers about what is a §1256 contract and what is not. For example, how will "single-stock futures" be classified? Plenty has been written about "single-stock futures" in Active Trader magazine. We expect to write an article about this in an upcoming issue of Active Trader, in Robert Green's Business of Trading column.

Wash sale rule and section 1256 contracts:
The wash sale rules that generally apply to losses from the sale of stock or securities don't apply to any loss arising from a section 1256 contract (which is marked to market at the end of the tax year). A section 1256 contract is any regulated futures contract, foreign currency contract, nonequity option, dealer equity option, or dealer securities futures contract.

Currency Trading:
Currency traders transact in contracts on regulated commodities exchanges (regulated futures contracts (RFC) on currencies) or in the non-regulated "interbank" market (a collection of banks giving third party prices on foreign current contracts (FCC) and other forward contracts).

Learn how currency traders are taxed similar to commodities traders, except that interbank currency traders must "elect out" of IRC section 988 (the ordinary gain or loss rules for special currency transactions), if they want the tax-beneficial "60/40" capital gains rate treatment of IRC section 1256.
Click here for our Currency Trading tax information page.

Single Stock Futures (SSF):
The IRS considers single-stock futures to be "securities futures contracts" (SFC). SFCs are taxed like their underlying securities (stock, options and narrow-based indices) and not like commodities (commodities, futures, FOREX and wide-based indices). Because of this, the gains are always short-term capital gains. Click here for our Single Stock Future tax information page.

Knowing the difference is very important in case a taxpayer qualifies as a trader in both securities and commodities. That trader might elect IRC §475(f)(1) for securities only and not elect IRC §475(f)(2) for commodities. That taxpayer would then have capital gain or loss treatment on §1256 contracts for commodities and ordinary gain or loss treatment on §475(f)(1) for securities. If that trader lost a large amount of money in a instrument, he or she would hope it was a security and not a §1256 contract. The reverse would apply if there was a large gain. We cover this in-depth in our below Guide.

For more information about commodities, Section 1256 contracts, Form 6781 and much more, we suggest you view our following guides. You can also click below to purchase them, or visit our Guide page.

Foreign Exchange Traded Futures:
The following question was asked on our GTT Message Board: "Are futures trades done on foreign exchanges also taxed at 60/40 for U.S. citizens, or does 60/40 only apply to futures listed on US exchanges." Click here for our Foreign Futures Tax Center page.

If you have any questions, e-mail us at info@greencompany.com or call us.

GTT Guide: 2004 Tax Return Examples for Commodities, Futures & Currency Traders (Individual and Entities) $49.95

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