A Section 1256 contract is an investment category that is identified by the Internal Revenue Code (IRC) as a regulated futures contract, foreign currency contract, non-equity option, dealer equity option, or dealer securities futures contract. This classification is important because it determines how the investment is taxed.
Regulated futures contracts are agreements to buy or sell a specific commodity or financial instrument at a predetermined price and date in the future. These contracts are traded on regulated exchanges, such as the Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange (NYMEX). Examples of commodities that can be traded through regulated futures contracts include agricultural products like corn and wheat, energy products like crude oil and natural gas, and financial instruments like stock indices and currencies.
Foreign currency contracts are agreements to buy or sell a specific amount of one currency for another currency at a predetermined exchange rate and date in the future. These contracts are also traded on regulated exchanges, such as the CME or the Intercontinental Exchange (ICE). Foreign currency contracts can be used to hedge against currency risk or to speculate on changes in exchange rates.
Non-equity options are contracts that give the holder the right, but not the obligation, to buy or sell a specific underlying asset at a predetermined price and date in the future. The underlying asset can be a commodity, a currency, or a financial instrument. Non-equity options are traded on regulated exchanges, such as the CME or the Options Clearing Corporation (OCC).
Dealer equity options are contracts that give the holder the right, but not the obligation, to buy or sell a specific stock at a predetermined price and date in the future. These contracts are not traded on regulated exchanges but are instead offered by dealers who specialize in these types of options.
Dealer securities futures contracts are agreements to buy or sell a specific security at a predetermined price and date in the future. These contracts are also not traded on regulated exchanges but are instead offered by dealers who specialize in these types of contracts.
The tax treatment of Section 1256 contracts is different from other types of investments. Gains and losses from these contracts are marked-to-market at the end of each year, which means that they are treated as if they were sold and repurchased at the current market price. This can result in higher taxes for traders who have unrealized gains at the end of the year. However, it can also provide tax benefits for traders who have unrealized losses, as these losses can be used to offset other types of income.
In addition, Section 1256 contracts are subject to a lower tax rate than other types of investments. Gains and losses from these contracts are taxed at a blended rate of 60% long-term capital gains and 40% short-term capital gains, regardless of how long the contract was held. This can be beneficial for traders who hold their contracts for less than a year, as short-term capital gains are typically taxed at a higher rate than long-term capital gains.
Overall, Section 1256 contracts can be a useful tool for investors who want to trade commodities, currencies, or options. However, it is important to understand the tax implications of these investments and to consult with a tax professional before making any trades.