EDUCATION CENTER
GTT RESOURCES: SECURITIES VERSUS COMMODITIES

See our Updated Trader Tax Center pages.

OLDER CONTENT: We cover this topic in chapter 3 of Green's 2012 Trader Tax Guide.

"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." Click here for our article on this subject, published by Active Trader magazine in their Aug. 2003 issue. Click here to learn more.

What tax rate does your future hold? Securities and futures exchanges are competing for your business with lots of new products. When choosing which ones look most attractive, add taxation to the mix; it could help reduce your tax rate by 12 percent. Click here for our article on this subject, published by SFO (Stocks Futures & Options) magazine in their Feb. 2004 issue. Click here to learn more.

Traders have a large variety of new financial products to trade: ETFs, E-Minis, single-stock futures, plenty of new indices, and options and futures on almost everything. Learn how all these new products are taxed – as securities or commodities – and consider that commodities have lower tax rates.

Good news! The Commodity Futures Modernization Act of 2000 (CFMA) created an entire new batch of financial products to trade, and the new indices created from the act are taxed as commodities, which have lower tax rates then securities.

Before you start incorporating some of the new financial products into your trading program it’s wise to see how these new products are taxed by the IRS. In general, all new products are either taxed as “securities” or “commodities” and the latter have lower tax rates. So when given the opportunity to trade a new product that is equivalent in all respects except tax treatment, it will pay tax-wise to chose the “commodity” taxed vehicle.

If you are a business trader, understand ahead of time how incorporating some of these new products into your trading program may affect your trader tax status and election for mark-to-market accounting (MTM).

For example, if you elected MTM for your securities trading business only (and not for commodities) and you revise your business plan to trade E-Minis almost exclusively, you won’t have ordinary loss protection on the E-Minis, as they are taxed as commodities.

Note: An edited version of this page content was published in the August 2003 issue of Active Trader magazine (in the "Business of Trading" section written by our Robert A. Green, CPA): "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."

We updated this page to reflect the new, lower tax rates put in effect after passage of the 2003 Tax Act: 35 percent on ordinary income and 15 percent on long-term capital gains. We point out the significantly lower tax rates that apply to commodities traders (23 percent) vs. securities traders (35 percent). Click here for the details.

Commodity Futures Modernization Act (CFMA) of 2000
H.R. 5660 Dec 14, 2000. The most significant aspect of this legislation was the legal creation of the single-stock future contract and taxation of broad based indices.

Taxation under the CFMA of 2000
Technical Explainations of the Tax Provisions of CFMA. If you want to learn more about the taxation of commodities, this is an excellent resource.

Products are more complex, but taxes have gotten simpler!
In the old days, before the Internet revolutionized online trading in 1997, a trader’s business and tax universe was in balance.

The SEC and CFTC kept to their respective turfs for securities and commodities, respectively, and the IRS taxed all instruments as either securities or commodities. The lines of demarcation were clear for all. Most traders focused on securities or commodities trading and few actively traded both.

Wow, have things changed with the passage of the CFMA and the simultaneous creation of an entire assortment of new product "hybrids."

Commodity exchanges created products to appeal to securities traders
The online trading revolution brought tremendous growth in the securities markets with the advent of hot IPOs. Trading in tech and NASDAQ stocks were all the rage in the late 1990s.
By 2000, the stock market bubble burst and securities and commodities exchanges actively began to compete for customers by creating new products that mirrored products created by the other exchange.

Commodities exchanges felt they missed the stock market windfall, so they rushed to market new flavors of “broad based” stock indices. Commodity exchanges were successful, partially because of the tax advantages for commodities traders (over securities traders).

Act and you shall find!
These new hybrid products created with the CFMA raised the ire of the SEC. This new Act solved many of the outstanding regulatory and tax treatment issues raised by these new products.

The CFMA established a framework for joint regulation (by the SEC and the CFTC) of single-stock futures and narrow-based security indexes.

IRS issues were also solved because the CFMA updated the IRS definition of “nonequity options” in IRC section 1256 contracts (commodities). Now, both the IRS and regulatory definitions of “broad based” indices are the same – 10 or more stocks in an index. This is great news for traders because now almost all indices are “broad based” and taxed at the lower commodity tax rates (see below).

Regulatory wise, broad-based security indices, which are not considered security futures products, continue to trade under the sole jurisdiction of the CFTC. Security futures products (i.e., single-stock futures) are subject to the joint jurisdiction of the CFTC and the SEC.

Methods for determining when an index is broad or narrow-based (for tax and regulatory purposes) are discussed at http://www.cftc.gov/sfp/sfpbackground.htm.

For indices excluded from the definition of narrow-based security index see http://www.cftc.gov/sfp/sfpcontractsapprovedprecfma.htm.

Under the CFMA almost all indices are now “broad based” commodities
The main effect of the CFMA was to significantly expand the definition of a “broad based” index, which is considered a commodity. “Narrow based” indices are considered securities.

Among assorted rules under the CFMA, the main rule states a “broad based” index is comprised of 10 or more securities; likewise, nine or fewer securities are a “narrow based” index.

Under the CFMA, almost all futures and options on stock indices, and smaller variations of indices (commonly known as “E-Minis”), are considered “broad based” indices, treated as commodities.

This is good news, because commodities have lower tax rates than securities and now almost all indices are commodities.

At the time of writing this article, we did not find one index that is considered “narrow based” and taxed as a security.

Single stock futures are taxed like securities
The IRS states that, "a gain or loss on the sale, exchange, or termination of a securities futures contract generally has the same character as gain or loss from transactions in the underlying security."

"For example, if the underlying asset would be a capital asset in the hands of the taxpayer, gain or loss from the sale of the contract is a capital gain or loss. This rule does not apply to securities futures contracts that are not capital assets (they are inventory assets), nor does it apply to products identified as hedging transactions, or any income derived in connection with a contract that would otherwise not produce a capital gain. Except as provided in the regulations, capital gain or loss from the sale, exchange or termination of a securities futures contract to sell property is treated as short-term capital gain or loss."

"A securities futures contract generally is defined as a contract of sale for future delivery of a single security or a narrow-based security index."

For more information on single-stock futures, click here.

Securities traders pay higher taxes
Before the mid-1980s, the IRS treated all buyer and sellers of “capital assets” (securities and commodities) in the same manner.

Securities trading “realized” gains are “short-term” capital gains subject to “ordinary” (marginal) tax rates, with the exception being that if you hold a security position open for 12 months or longer, you benefit from a lower long-term capital gains tax rates (20 percent vs. 38.6 percent). To pay for long-term capital gains rates, Congress subjects securities traders to the onerous wash-sale loss and straddle-loss deferral rules. Few securities traders keep positions open for 12 months, so they pay the higher tax rate and are also penalized with wash sale and straddle rules. This is simply not fair, but it is the rule.

In general, “securities” include: stocks, stock options (equity options), narrow-based indices, single-stock futures (taxed like their underlying stocks), mutual funds, exchange traded funds (QQQs, iShares, SPDRs, etc.) and bonds.

The taxability of options on ETF shares, where the underlying portfolio or index is “broad based” is currently uncertain and requires guidance from the IRS.

Commodities traders pay lower taxes
In the mid-1980s, Congress and the IRS significantly changed the tax code to provide for important differences between securities and commodities taxation.

Shrewd commodities traders were setting up complex straddles (offsetting positions) to avoid taxes by accelerating realized losses in the current tax year and deferring the offsetting unrealized gains positions to the next tax year.

Congress and the IRS passed IRC Code section 1256 to close this tax shelter. Section 1256 defines commodities and sets forth beneficial tax treatment for commodities.

Form 6781 apportions commodities gains and losses to Schedule D (Capital Gains and Losses) with 60 percent long-term and 40 percent short-term. Securities trading gains are all short-term on Schedule D, unless a trader holds a security open for 12 months or longer (a rarity for traders).

As mentioned previously, long-term capital gains rates are significantly lower than short-term rates. The 2003 Tax Act lowered long-term rate to 15 percent and the short-term rate to 35 percent.

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.

Commodities defined
The definition of “commodities” in IRC Section 1256 include: any regulated futures contract, any foreign currency contract, any non-equity option, any dealer equity option and any dealer securities futures contract.

The big news in the CFMA is the updated definition for “non-equity options,” which include “broad-based” indices. “Narrow based” indices are considered “equity options” and taxed as securities. Options relating to broad-based groups of stocks and broad-based stock indices will continue to be treated as “non-equity options” under section 1256.

Congress helped traders tax-wise
I applaud Congress for acting in a smart manner in their passage of the CFMA.

Traders are not investing in long-term securities, but instead looking to trade any feasible instrument for a quick swing in price for profit.

For traders, it’s a zero sum game. Now with the CFMA, all those new indices are treated as commodities and commodity tax law is better for traders. Commodities are marked-to-market at the end of each day (which is the way a trader thinks), and the tax rates are lower.

Congress needs to do more work and help more traders avoid the tax pitfalls of securities taxation. Traders can help themselves with an IRC Section 475 mark-to-market election to avoid wash sales, straddle rules and capital-loss limitations.

Special rules for currency trading
Currency traders transact in contracts on regulated commodities exchanges (regulated futures contracts [RFC] on currencies – Section 1256 commodities) or in the non-regulated "interbank" market (a collection of banks giving third-party prices on foreign current contracts [FCC] and other forward contracts).

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. The principal intention of IRC section 988 is taxation on foreign currency transactions in a taxpayer's normal course of transacting global business.

Most currency traders will want to make this election for the tax-beneficial treatment of section 1256 (lower tax rates on gains).

For more information on currency trading, click here.

Bottom line
For tax purposes, don’t be alarmed when you see an ever-growing list of financial products to trade. How an item is taxed is not dependent on the type of exchange it trades on. The current law that matters is the CFMA, and the law actually simplified tax matters. Almost all indices are 10 or more stocks (broad-based) and taxed like commodities. Single-stock futures and ETFs are taxed like securities. When you have a choice, choose the commodity for lower tax rates (60/40).

If you have any questions on the CFMA, contact us at info@greencompany.com or call us.

Ready for a consultation with a GTT CPA

Don’t Let the Taxing World of Investment Taxation Baffle You

By Robert A. Green, CPA

Let’s assume you are interested in trading a NASDAQ 100 instrument because you are not an expert in any one particular stock and like the broad nature of indexes instead. Next, notice that security and commodity exchanges are competing for your business by offering you a few choices in tradable NASDAQ 100 instruments. You can trade the NASDAQ 100 TRUST (QQQ), an exchange traded fund (ETF). Alternatively, you can trade the E-mini NASDAQ 100 (NQ), a smaller electronically traded version of the NASDAQ 100 stock indexes, compliments of the Chicago Mercantile Exchange.

What you may not know is that there are some significant differences in taxation for the above two choices.

The QQQ, like all ETFs, are taxed like securities, with short-term ordinary tax rates up to 35 percent. The NQ, however, is taxed like most futures contracts with the more tax-beneficial 60/40 tax treatment. Sixty percent of trading gains are considered long-term (with maximum tax rates up to 15 percent), and 40 percent are considered short-term (with maximum tax rates up to 35 percent). The maximum blended rate on commodities is 23 percent, which is 12 percent lower than the maximum rate on securities. Wow, it suddenly occurs to you that you can save a bundle on trading the NQ versus the QQQ. Just make sure that all other factors for these competing choices do not trump the tax benefits.

Commodities have lower tax rates than securities, and there are also other important differences in taxation. Simply, commodities are marked-to-market (by default) and, therefore, are exempt from important tax rules that affect securities including: wash sales; straddles and constructive receipt; and holding periods.

Certainly, there are many other rules and nuances that traders should understand before they start trading a given instrument, so be careful to read the fine print; a product name does not always indicate how an instrument is taxed.

The Markets Are Ahead of the IRS
Former U.S. Treasury Secretary Paul O’Neil called the tax code an abomination that needed to be scrapped and redone from scratch. He “retired” early, and few pundits expect his vision to be executed. Thus, we are all stuck with this abomination for some time to come.

And, of course, the tax code is a work in progress. Congress uses “fiscal policy” to encourage, reward and punish certain kinds of business and investment behavior. Some of it may be labeled pork-barrel politics, but some also is truly useful.

In the case of taxation for securities and commodities, the current state of the law does not have an equal playing field. Even though many types of securities trade like commodities with a “zero-sum game,” Congress has reacted to different events over the years and caused a “great divide” between taxation for securities versus commodities.

In the 2003 Act, Congress sought to close this gap, but powerful commodity exchanges and lobbyists saved their cherished 60/40 treatment from being repealed (in the last minute of a conference bill). It is anticipated that Congress will try to close current gaps (in securities versus commodities) again soon. In the meantime, many traders will seek to profit from these gaps.

In the Eyes of the IRS, It’s Either a “Security” or a “Commodity”
In the mid-1980s, Congress acted to stop widespread abuse by professional commodity traders who were using straddles to avoid income taxes. They would have offsetting positions and close losing positions in the current tax year while keeping open their offsetting profitable positions through year-end. To stop this abuse, Congress passed new, sweeping legislation to provide for IRC Section 1256 contracts, which included most commodities and futures contracts on commodities exchanges. This was the first significant divorce of commodities and futures from securities.

The most important element of IRC Section 1256 contracts was mark-to-market accounting (MTM), which provided that all positions at year-end would be treated as if sold at year-end using year-end prices. This had the immediate chilling effect of killing off the use of commodity straddles for tax avoidance. Now, both losing and profitable offsetting positions would be reported in the current tax year. Clearly, MTM changed many important fundamentals in the tax code, which favored long-term investing.

Is It a “Capital Asset” or a Hedge for Business?
Before Congress passed IRC Section 1256 legislation in the 1980s, all securities and commodities were subject to tax laws for “capital assets” versus ordinary business transactions. Traders and investors purchased securities as “capital assets” to potentially generate a gain from speculation, rather than as part of a business operation. Similarly, a trader speculated in corn futures without any commercial interest in the commodity, and generated more tax-favorable “capital” gain and loss treatment. But the corn farmer who hedged his crop with corn futures did it as part of his business’s risk-aversion strategy, and generated “ordinary” gain or loss treatment.

Unless an item is defined in IRC Section 1256, IRC Section 988 (the currency rules stated later in the article) or another code section, it is subject to the general rules for “capital assets.”

Congress Rewards Long-Term Investments In “Capital Assets” (Securities)
The tax rules for businesses are fairly straightforward. Add up revenues, deduct all business expenses, and the resulting net profit is taxed at ordinary income tax rates.

Ordinary tax rates are high, but at least a business can deduct every possible business expense without restriction.

Congress passed a complex body of rules for investment activity, and these rules have not aged well. Here’s the bargain: Hold a “capital asset” long enough (currently 12 months), and pay a lower tax rate – currently 15 versus 35 percent – a significant difference per the 2003 Tax Act. But fiscal policy usually comes with both a carrot and a stick. To balance the budget on lower long-term capital gains rates, Congress applies a series of rules to prevent abuses and to raise revenue.

Don’t Let Congress Wash Your Savings Away With “Wash Sale” Rules
Congress used MTM for Section 1256 to stop traders from avoiding taxes by reporting loss positions and deferring offsetting profitable positions. The original tax rule to stop a similar type of practice is still on the books, and it’s a royal pain for active securities traders – the wash sale rules.

If you re-enter a losing positions within 30 days before or after selling a losing position, you are hit with the dreaded wash sale loss deferral rule. These rules are highly complex and beyond the scope of this article. But, bottom line, if you trade commodities and futures (IRC section 1256 contracts) or elect IRC 475 (the new mark-to-market accounting rules for business traders), you are exempt from the wash sale rules. What a relief! Congress thinks the wash sale rules are fair because they don’t want traders taking short-term losses (at the higher tax rate for benefits) and then paying taxes later on at the lower long-term rates.

Have a Loss? Good Luck Trying to Deduct It.
The greatest problem for traders is the dreaded “capital loss limitation” rules. It’s a puny net deduction on capital losses of $3,000 per year for individuals (zero for corporations), and it has not been indexed for inflation or raised in decades. Come on! Please! What trader can’t lose $3,000 in one hour’s time, let alone over a year?

Congress changed the laws in 1997 for those who qualify as business traders to allow ordinary gain or loss treatment like other businesses. If you elect IRC Section 475 on time, you are exempt from the dreaded capital loss limitation (and wash sale) rules and may take unrestricted ordinary deductions for your trading losses. But not every trader qualifies for business treatment, and most don’t know about MTM IRC 475 before it’s too late.

Commodity and futures traders catch another break. They are permitted to carry back IRC Section 1256 contract trading losses three tax years, but only to be applied against Section 1256 contract trading gains.

Capital loss limitations are an abomination for traders. Most traders do not hold positions for more then a month, and most day- or swing-trade. They have no reasonable prospect of ever getting that carrot – long- term capital gains benefits – so why penalize them with wash sales and capital loss limitations?

Is It a Security or a Commodity? That Is the Question
There has been a bevy of new financial products launched by securities and commodities exchanges the past few years, including but not limited to ETFs, E-minis, single-stock futures, plenty of new indices, and options and futures on almost everything. Commodity futures exchanges rushed to market securities-like products to mimic the trading in indexes rather then miss the equities bubble boom. And electronic exchanges like OneChicago, LLC, and NQLX offered securities futures contracts (single stock futures) and ETF futures. Competing exchanges stepped on each other’s turf.

But, product names are not indicative of tax treatment and are intended to draw attention and use by traders. Before starting to trade a new product, find out how it’s taxed – as a security or a commodity.

Single Stock Futures – Security or Commodity?
One of the new financial products to trade are “single stock futures” (SSF). Many traders and professionals alike are still confused about how they are taxed. Single stock futures, called “securities futures contracts” by the IRS, sound like (and trade like) a futures product, normally taxed as a commodity. However, SSFs are taxed like securities.

Here's the simplistic rule of thumb. Figure all new products are taxed as either a security or a commodity.

Next, consider that many new financial products are a combination or representation of other securities and/or commodities. Try to figure out whether the product resembles a security or a commodity. For example, with single stock futures, the product may act like a future, but the underlying product is one security and the SSF product resembles that underlying security. In fact, that is why the IRS states SSFs are taxed like securities.

Indexes – Security or Commodity? It Depends.
Next, apply this same logic to stock indexes. There has been a rash of new stock indexes from various exchanges, providing traders with new means to trade securities markets. To date, most of these new indexes are, in fact, taxed like commodities, but some of the new ones are taxed like securities. New coordinated legislation in 2000 from the IRS, Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) set the new general rule.

Extending the above logic for SSFs, if the product trades like one or a few securities (the cut-off is set at nine), it is defined as a “narrow-based” index and taxed like a security. Conversely, if the index is comprised of ten or more securities, it is considered a “broad-based” index that resembles a commodity.

To date almost all indexes are comprised of ten or more securities, and therefore, are taxed like commodities with the beneficial 60/40 treatment. But a few aren’t. OneChicago, LLC one of two U.S. futures exchanges originally established to offer single stock futures and related products, last summer introduced 15 futures on the Dow Jones MicroSector Indexes. Each of the 15 is a narrow-based index that includes five of the largest and most actively traded stocks in an industry sector. These narrow-based indexes are taxed like securities.

Forget the Rule of Thumb: Give Me a List of Securities, Please
OK, let’s just break this down to make it easier. Securities include but are not limited to:

• Exchange Traded Funds (ETFs) including QQQ, DIA and SPDRs;
• Stocks, stock options, mutual funds, and bonds;
• Single stock futures, otherwise known as “non-dealer securities futures contracts;”
• By default, any “capital asset” that is not otherwise defined as an IRC Section 1256 contract (a commodity) or IRC Section 988 (currencies, inter-bank foreign exchange or FOREX). For example, gold bullion sounds like a commodity or currency, but physical gold is neither included in IRC section 1256 or 988, and it’s taxed like securities. That means if you hold gold bullion bars for more than 12 months, you are entitled the lower long-term capital gains rate (currently 15 percent).

The taxability on options on ETFs, where the underlying portfolio or index is broad-based, is currently uncertain and requires guidance from the IRS.

Which Do I Want to Trade, Security or Commodity?
If you want to buy and hold a product for the long-term and are not worried about large non-deductible capital losses, then the best choice is a security. You can pay taxes at the lower long-term capital gains rates (up to 15 percent).

If you plan on buying and selling in a short period of time – the focus of most business traders, and want a built-in carry-back loss feature, then the best choice is a Section 1256 contract, which includes most commodities and futures traded on exchanges. You can pay taxes at the lower blended long-term/short-term (60/40) rates up to 23 percent.

If you are a securities business trader, then elect IRC 475 to have mark-to-market accounting on securities. Your trading gains are taxed at the higher ordinary tax rates (up to 35 percent) whether you elect MTM or not. And with MTM, you are exempt from the onerous wash sale loss and capital loss limitation rules.

It is possible to have the best of all worlds. You can trade 1256 contracts for 60/40 treatment, business trade securities with MTM loss protection, and “segregate” investments in securities for long-term capital gains with deferral (until you sell).

Here’s the Skinny on Section 1256 Contracts.
Special tax rules apply to IRC section 1256 contracts. By definition, they include:

• Any regulated futures contract (i.e. commodities and futures contracts on U.S. commodities exchanges;
• Foreign currency contracts (traded on exchanges, but not including FOREX or inter-bank trading; see special rules for IRC 988 below);
• Non-equity options or dealer equity options (i.e. these are the “broad-based indexes” discussed above, including but not limited to the NASDAQ 100, Dow and S&P futures contracts);
• Any dealer securities contracts (not the same as “non-dealer” securities futures contracts – single stock futures. If you are not a dealer, then it’s non-dealer and not 1256).

Section 1256 contracts are marked-to-market (MTM) each day and at year-end. This means that you report both realized and unrealized gains and losses. MTM doesn't apply to certain hedging transactions.

There is a newer and different type of mark-to-market accounting treatment that is part of IRC Section 475; don’t confuse IRC 475 with IRC 1256. In 1997, Congress expanded IRC 475 from covering “dealers” only to also covering “traders in securities and/or commodities.” IRC 475 converts “capital” gains and losses into “ordinary” gains and losses. Commodity traders usually skip IRC 475 elections because they want to retain the more favorable 60/40 lower capital gains rates on gains. Securities traders prefer to elect IRC 475 because their gains are already taxed at ordinary tax rates. So why not have ordinary loss treatment (rather than be encumbered with capital loss limitations)? To use IRC 475, a trader first must qualify for “trader tax status” (business treatment) and elect IRC 475 on a timely basis (by April 15 of the current tax year or within 75 days of inception for “new taxpayers”).

Section 1256 MTM is still considered “capital gains and losses” and, in fact, after reporting Section 1256 contracts on Form 6781, the net results are then transferred to Schedule D (Capital Gains and Losses). So, you are subject to the $3,000 capital loss limitation, although you benefit from 60/40 tax treatment (the lower blended rate of 23%).

Many traders overlook a built-in loss carry-back feature in Section 1256. You can carry 1256 contract losses back three tax years, but only against Section 1256 gains in those years. This loss carry-back feature is narrower then the net operating loss carry-back benefit opportunities caused by ordinary loss treatment in IRC 475 MTM (for business traders only). Net operating losses can offset any type of income in the prior two tax years (Congress may extend to five-year carry-backs).

Now I’m Confused. Which MTM Is Right for Me?
All traders in Section 1256 contracts automatically use MTM. That’s the only way your brokers will report this activity to you.

When it comes to securities, all investors and business traders use the “cash method” by default. Business traders are entitled to elect the new MTM IRC Section 475 that converts restricted capital losses (and gains) into unlimited ordinary losses (and gains).

Profitable Section 1256 contract traders should not elect IRC 475 MTM to trump their Section 1256 MTM; that would raise their tax rate by 12 percent on gains and result in a better loss potential (but for most it’s not worth the added tax rate).

If you trade ETFs, single stock futures and narrow-based indexes and qualify for trader tax status (business treatment), then IRC 475 MTM is a good election (so make sure to elect it on time by April 15th of the current tax year, or within 75 days of inception for “new taxpayers”). Gains are taxed at the same ordinary tax rates, but with MTM, you unlock unlimited ordinary loss potential (for immediate tax refunds, rather then deferred unutilized capital losses).

Skip It – Let My Broker Tell Me What I Made and How to Report It
Well, that may be fine for Section 1256 contracts, but not for securities and currencies.

Around February, your broker mails you (with a copy to the IRS) a Form 1099-B, which reports some of your brokerage firm activity for the year. Actually, most brokers only report the minimum information required by IRS law.

Here’s the bottom line. You cannot prepare your tax returns based on Form 1099s, but will have more luck with Supplemental Information provided by your broker. If you have lots of transactions or use a direct-access or online broker, you also will need more help.
Accounting software programs can help a lot. GTT TradeLog from this writer’s company was positively reviewed by the media, and it’s considered a robust product for active traders.

Here are a few other things you need to know about the limitations of Form 1099-B:

• Currently may omit single stock futures;
• Only report proceeds on sales of securities, not purchases, and they do not match buys with sells;
• Does not report option proceeds or purchases, although most Supplemental Information pages do;
• Does not account for wash sales or MTM on securities;
• Does not account for FOREX trading;
• Are based on “trade date,” but monthly statements showing opening and closing positions (needed for accounting), are based on “settlement date.”

Remember, the Form 1099-B is an informational statement with bare bones reporting, and it’s not meant to state what you made or lost with a brokerage firm. It’s not like other 1099s (Misc or R) or a Form K-1 or W-2, all of which do report your actual income or loss.

Many brokers have online reports, but often there are unmatched trades and there’s no account of wash sales and/or MTM.

If you don’t properly report your income to the IRS, you are subject to penalties and interest, including some large extra penalties for understating your taxes with negligence. Get the help you need early on.

With SSFs, Start Holding Period Early For a Long-Term Capital Gain
A securities futures contract is basically a contract of sale for the future delivery of a single security or a narrow-based security index. If a taxpayer takes deliver on the underlying security, their holding period starts from the date of the original purchase of the securities futures contract. That’s helpful for achieving a 12-month hold; for a lower long-term capital gains tax rate.

Currency Trading – Special Tax Rules Apply
Currency traders transact regulated futures contracts on regulated commodities exchanges (treated as Section 1256 contracts) or in the non-regulated "interbank" market (a collection of banks giving third-party prices on foreign current contracts (FCC) and other forward contracts).

By default, FOREX or inter-bank trading is not included in Section 1256; rather it’s subject first to IRC Section 988, which specifies tax treatment for foreign currencies.
The principal intent of IRC Section 988 is taxation on foreign currency transactions in a taxpayer's normal course of transacting global business. For example, if a manufacturer purchases materials in a foreign country in a foreign currency, then the fluctuation in exchange rates gain or loss should be accounted for pursuant to IRC 988.

So what’s IRC 988? Simply, it provides that these fluctuations in exchange rate gains and losses should be treated as ordinary income or loss and reported as interest income or interest expense. IRC 988 considers exchange rate risk in the normal course of business to be like interest.

When a currency trader uses the interbank market to transact in foreign currency contracts and other forward contracts, he is exposed to foreign exchange rate fluctuations, similar to a manufacturer mentioned above. However, the currency trader looks upon his currency positions as "capital assets" in the normal course of his trading activity (business or investment). The “capital asset” rules apply. What this means is that a currency trader may elect out of ordinary gain or loss treatment in IRC section 988, thereby qualifying to use section 1256 contract treatment – which is 60/40 capital gains and losses. Most currency traders will want to make this election for the tax-beneficial treatment of section 1256 (lower tax rates on gains).

And, those with large FOREX trading losses may be better to skip IRC 1256 and take an ordinary tax loss. You need to make the election on a “contemporaneous basis” in your own books and records; which means you are not supposed to pick and choose the best approach after-the-fact.

Bottom Line
Don’t let the tail (taxes) wag the dog (trading). Put your trading affairs in tax order. Buy and hold “segregated” investment securities for deferred 15-percent tax rates. Trade commodities, futures and broad-based indexes for a lower 23-percent blended tax rate (60/40 treatment on IRC Section 1256 contracts). Try to qualify for trader tax status and elect IRC 475 on securities only for added tax loss insurance. If you are not sure, ask your broker and accountant; this will prevent surprises at year-end. There are a number of other differences between all the new products besides taxes (margin, risk, investment sizes, selling features, and more).

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