Value Microcaps Motherboard

[jtomm]

Index Option Taxes - 1256 Contracts

Many index options are now considered 1256 contracts. I'm pretty sure this changed only in the last few years, because I've traded index options in the past, and I'd swear it was always regular Sched. D reporting. I'm guessing some short term trader got hold of a Congressman and finagled a better tax deal for himself.

Here's how I know about this. I got a bit of a surprise last year when doing taxes. I had received my Ameritrade tax statement, but didn't really look at it closely until a few days before filing date, when I started preparing stuff. Turns out, there was a section marked "1256 contracts." It was a surprise to me too. Prior to receiving that, I would have told you that nothing you can buy through Ameritrade is a 1256 contract. But apparently most "broad-based" index options are now considered 1256 contracts. And the definition of "broad-based" is getting narrower.

If anyone is not familiar with the term, 1256 contracts is the tax terminology for futures, futures options, etc. I'd traded that stuff in the past, so I knew what it was, but was shocked to see it on an Ameritrade statement. But apparently the IRS is now calling many index options "non-equity options" that come under heading of 1256 contracts. (I had to scramble at the last minute last year to get the right paperwork for filing).

1256 contracts can be both good and bad. For tax purposes, 1256 contracts are marked to market at the end of the year and you pay taxes on the gains, whether you've taken them or not. This might lead to a surprise for someone who had big gains on something at the end of the year, is still holding in say, March, but by then the price is down significantly. You could end up having to pay cash taxes while you're still holding the position which may or may not be a winner at that point. (You can recover the difference in future years and so forth, but it still could be a shocker.) Luckily my position was cashed out during the same year, so I didn't get a surprise. But I could've gotten caught, because I had no idea that anything bought through Ameritrade could be a 1256 contract.

That's the bad possibility of the tax issue. The good thing about 1256 contracts is they are divided into 60% long term capital gains, and 40% short term, no matter how long you hold them. Make a ten-day trade, and it's divided 60% long term, 40% short term. That could be pretty nifty for short term stuff.

But not as great for long term. Even if you hold more than a year, it's still divided 60/40.

From what I'd found on the internet, it sounds like index options based on more than 9 or 10 underlying stocks are considered "broad-based" and thus, 1256 contracts. But I wouldn't trust the internet, check with your broker. I think ETF's are still sort of in limbo. Are options on SPY considered "broad-based," or does the IRS consider that one stock? Who knows. I'll be checking with my broker whenever I trade ANY index options from now on, so I can adjust my strategy.

Depending on your individual tax rate, if you plan on holding something more than a year, you probably DO NOT want to be trading a 1256 contract. If you plan on holding something less than a year, 1256 contracts give you a better tax rate, but you have to remember the mark to market aspect at the end of the year.

http://finance.yahoo.com/taxes/tips/invest/article/100282/Index_Options_Over_ETFs