SECTION 1256 CONTRACTS
A Section 1256 Contract is any:
(1) Regulated Futures Contract
(2) Foreign Currency Contract
(3) Nonequity option
(4) Dealer equity option
Section 1256 Contracts are subject to special tax rules. Section 1256 contracts are marked-to-market by law, which means that a contract held at the end of the tax year is treated as if sold at its fair market value on the last business day of the year and you must include this unrealized gain or loss in your taxable income for the year. This unrealized gain or loss becomes an adjustment to the cost basis and reverses itself in the following year when the contract is actually sold.
60% of the capital gain or loss from Section 1256 Contracts is deemed to be long-term capital gain or loss and 40% is deemed to be short- term capital gain or loss. Gain or loss and the 60/40 split from these contracts are reported on IRS Form 6781.
Due to the volatile nature of these securities, a special loss carryback election is allowed. Net Section 1256 Contracts Losses can be carried back 3 years instead of being carried forward to the following year. These losses can only be carried back to a year in which there is a net Section 1256 Contracts Gain, and only to the extent of such gain, and cannot increase or produce a net operating loss for the year. The loss is carried back to the earliest carryback year first and any unabsorbed loss can then be carried to each of the next two years.
A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you:
(1) Buy substantially identical stock or securities
(2) Acquire substantially identical stock or securities in a fully taxable trade
(2) Acquire a contract or option to buy substantially identical stock or securities
Losses from wash sales are not deductible. The disallowed loss is added to the cost of the new stock or securities, resulting in a new basis for gain or loss for the new security. This adjustment has the effect of postponing the loss deduction until the disposition of the new security.
Almost all day traders have numerous wash sales during the year, as they tend to trade the same security or basket of securities over and over. If these wash sales are recorded properly, they become a record keeping nightmare.
One of the advantages of a Section 475 election is that wash sale rules no longer apply to a qualified trader who has properly elected Section 475.