Section 1256 contracts receive special tax treatment that can significantly reduce your tax bill compared to regular short-term capital gains. If you trade futures, index options, or certain other derivatives, understanding Section 1256 is essential for tax planning.
What is Section 1256?
Section 1256 of the Internal Revenue Code provides special tax treatment for certain types of financial contracts. The key feature is the "60/40 rule" where gains and losses are treated as 60% long-term and 40% short-term capital gains, regardless of how long you held the position.
The 60/40 Rule: No matter if you hold a Section 1256 contract for one minute or one year, 60% of your gain or loss is treated as long-term (lower tax rate) and 40% is treated as short-term (ordinary rate).
What Qualifies as a Section 1256 Contract?
The following instruments qualify for Section 1256 treatment:
Regulated Futures Contracts
- Stock index futures (ES, NQ, YM, RTY)
- Commodity futures (CL, GC, SI, ZC, ZW)
- Currency futures
- Interest rate futures (ZB, ZN)
Foreign Currency Contracts
- Certain forex contracts traded on regulated exchanges
- Does not include spot forex (different rules apply)
Non-Equity Options
- Broad-based index options (SPX, RUT, NDX, VIX)
- Options on futures
- Cash-settled index options
Dealer Equity Options
- Options traded by market makers
- Does not apply to retail traders
What Does NOT Qualify
These instruments do not receive Section 1256 treatment:
- Stock options: Options on individual stocks (AAPL, TSLA, etc.)
- ETF options: Options on SPY, QQQ, IWM, and other ETFs
- Individual stocks: Regular equity trades
- Narrow-based index options: Sector-specific indexes
- Spot forex: Has separate rules under Section 988
SPX vs SPY Options
This is a common point of confusion:
- SPX options: Section 1256 - 60/40 treatment
- SPY options: Regular capital gains - short or long-term based on holding period
Both track the S&P 500, but only SPX options get the tax benefit.
Tax Savings from Section 1256
The 60/40 rule provides a blended tax rate lower than short-term rates:
Tax Rate Comparison
Assume 37% ordinary income rate and 20% LTCG rate:
- Regular short-term: 100% x 37% = 37%
- Section 1256 blended: (60% x 20%) + (40% x 37%) = 12% + 14.8% = 26.8%
- Tax savings: 10.2 percentage points
On $100,000 in gains: $10,200 in tax savings
Mark-to-Market at Year End
Section 1256 contracts are automatically marked to market at year end:
- Open positions are treated as if sold on December 31
- Gain or loss is recognized even without selling
- New cost basis equals year-end market value
- Creates potential "phantom" income on paper gains
Loss Carryback Provision
Section 1256 includes a unique loss carryback feature:
3-Year Carryback: Net Section 1256 losses can be carried back up to 3 years to offset Section 1256 gains from those years. This can generate a refund from prior year taxes.
How the Carryback Works
- Calculate your net Section 1256 loss for the current year
- Carry the loss back to the earliest of the 3 prior years with Section 1256 gains
- The loss retains its 60/40 character
- Can only offset prior Section 1256 gains (not other capital gains)
- File Form 1045 or amended returns to claim the refund
Carryback Example
Your Section 1256 trading history:
- 2023: $50,000 gain (tax paid)
- 2024: $30,000 gain (tax paid)
- 2025: $20,000 gain (tax paid)
- 2026: $80,000 loss
You can carry back the $80,000 loss to offset the gains from 2023-2025 and receive a refund of taxes previously paid.
Reporting Section 1256 Contracts
Section 1256 contracts are reported on Form 6781:
Form 6781 Basics
- Part I: Section 1256 gains and losses
- Part II: Straddles (if applicable)
- Net gain/loss: Transferred to Schedule D
- 60/40 split: Form separates long and short-term portions
Broker Reporting
Your broker reports Section 1256 contract activity on Form 1099-B. They typically provide:
- Aggregate profit or loss for the year
- Already calculated as Section 1256 treatment
- Includes year-end mark-to-market
Strategies for Section 1256 Contracts
Use Index Options Instead of ETF Options
When possible, trade SPX instead of SPY options, or NDX instead of QQQ options, to capture the 60/40 benefit.
Day Trade Futures
Day trading futures receives 60/40 treatment. Day trading stocks results in 100% short-term treatment.
Consider Tax-Loss Harvesting
Section 1256 losses can be carried back, making losses potentially more valuable than in regular trading.
Track Your Section 1256 Gains
Pro Trader Dashboard automatically separates your Section 1256 contracts from regular trades and calculates your blended tax rate. See your true after-tax returns.
Section 1256 and Straddles
If you hold offsetting positions (straddles), special rules may apply:
- Losses may be deferred
- Holding period may be affected
- Interest and carrying charges may need capitalization
- Consult a tax professional for complex strategies
Mixed Straddle Election
If you have straddles involving both Section 1256 and non-1256 positions, you may make a mixed straddle election to treat all positions consistently.
Section 1256 vs. MTM Election
Both involve mark-to-market treatment but are different:
Key Differences
- Section 1256: Automatic for qualifying contracts, 60/40 treatment
- Section 475 MTM: Elective for traders, 100% ordinary income/loss
- Can you have both? Yes - MTM election typically excludes Section 1256 contracts
Common Section 1256 Mistakes
- Confusing ETF options with index options: SPY options are not Section 1256
- Forgetting year-end mark-to-market: Taxes owed on unrealized gains
- Not using loss carryback: Missing out on potential refunds
- Incorrect Form 6781: Errors in reporting
- Ignoring state tax treatment: Some states do not conform to federal 60/40
State Tax Considerations
State treatment of Section 1256 varies:
- Most states follow federal 60/40 treatment
- Some states treat all gains as ordinary income
- A few states have no income tax at all
- Check your specific state's rules
Summary
Section 1256 contracts provide favorable 60/40 tax treatment for futures and broad-based index options. This can significantly reduce your tax burden compared to short-term capital gains treatment. The automatic mark-to-market and loss carryback provisions add additional complexity but also opportunity. When choosing between similar instruments (like SPX vs. SPY options), the tax treatment can be a deciding factor.
Learn more about trading taxes in our guides on options tax treatment and tax-efficient investing strategies.