Trader tax treatment options

By Robert A. Green, CPA
The 2009 tax-extension deadlines — Sept. 15 for entities and Oct. 15 for individuals — are quickly approaching. If you’re preparing your 2009 taxes or thinking ahead to 2010, now is a good time to review how various trading instruments are treated tax-wise.

Traders have a growing selection of instruments to choose from and it’s not always clear how the IRS taxes them. This determination is crucial, since futures are taxed at lower rates (currently up to 23 percent), while short-term securities are taxed at higher income tax rates (currently up to 35 percent — a 12-percent difference). Rates change, but there should always be a significant differential as long as Congress provides a tax advantage to futures traders.

Distinguishing between securities, futures, and forex can be confusing. The following sections  list the instruments included in each group, and the important details you need to know.

Securities
Securities include stocks, equity options, mutual funds, bonds, ETFs based on securities, single-stock futures, and narrow-based indices (a narrow-based index is one that is made up of nine or fewer securities). Because a single-stock future is based on one underlying stock, it’s treated like a stock.

Securities are reported on Schedule D where short- and long-term capital gains rates apply. Short-term rates are the ordinary tax rates.
Because taxpayers can play games with offsetting positions, the IRS has passed rules for wash sales, straddles, constructive receipts, and shorting against the box. Qualifying business traders often elect Section 475 marked-to-market (MTM) on securities, which eliminates these tax-loss deferral rules. With MTM economic reporting, the trader reports both realized and unrealized gains and losses, as nothing is deferred.
Schedule D capital losses are limited to $3,000 per year against ordinary income, whereas Section 475 MTM losses are unlimited.

Futures and commodities
Futures and commodities contracts traded on U.S. exchanges are subject to lower tax rates in Section 1256. Foreign futures don’t automatically qualify as Section 1256 contracts, but they may if the foreign exchange has received special approval letters from the U.S. Commodity Futures Trading commission (CFTC) and IRS. Precious metals are treated differently from base metals. The details involve the “collectible” tax rate on long-term capital gains, which is currently as high as 28 percent vs. standard long-term capital gains tax rates, which are currently up to 15 percent otherwise.

Futures contracts receive 60/40 tax treatment — 60 percent are automatically considered long-term capital gains (including day trades), and 40 percent are classified as short-term capital gains. MTM applies to Section 1256 contracts by default. With the default cash method, only realized gains and losses on securities are reported for the tax year. Securities traders using the cash method may defer unrealized gains (or losses) on open positions until realizing a gain (or loss) on a sale. Long-term capital gains tax rates apply to securities held for 12 months or longer.
Section 1256 contracts include commodities and futures on U.S. exchanges; foreign futures where the foreign exchange received CFTC and IRS approval letters (if it did not, the contract is treated as a security); broad-based indices (defined as being made up of 10 or more securities); options on indices; non-equity options; options on futures; ETFs based on commodities or futures; and options on ETFs (according to many tax professionals).

Even though ETFs can include more than 10 securities, they’re normally treated as securities, but ETFs based on commodities or futures are taxed as futures. Gold ETFs based on holding underlying physical gold receive the 28-percent collectibles tax rate if held long-term. The IRS has promised (but has not yet issued) guidance on options on ETFs. Most accountants and tax lawyers believe they can be treated like futures. You may have a choice here.

Commodities and futures trading professionals should also learn about the “mixed straddle election” and “hedging rules” in Section 1256(d) and (e), and as discussed on Form 6781. Offsetting positions between Section 1256 contracts and securities can generate some tax complications under certain circumstances involving the hedging rule. The IRS is concerned about some traders reporting Section 1256 MTM unrealized losses, and deferring unrealized gains on offsetting securities positions. It’s beyond the scope of this article.

For the complete article, see the September 2010 issue of Active Trader magazine. Click here to subscribe.



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