Mark-to-market for 1256 contracts and the straddle rules

Education, not tax advice: rules, rates and thresholds change every year, so confirm anything you plan to act on with a qualified tax professional.

The last lesson covered the friendly parts of Section 1256. This one covers the part that surprises people in their first futures year, mark-to-market at December 31, and then introduces the straddle rules, which exist to stop traders from using offsetting positions to manufacture deductible losses.

Mark-to-market at year end

Every 1256 contract you hold open on December 31 is treated as sold at its fair market value on that day. The resulting gain or loss is included in the year's Form 6781 total. On January 1 your basis resets to that December 31 price, so the same gain or loss is not counted twice.

This is the opposite of stock treatment. With shares, an open position is invisible to the tax return. With futures, an open position is taxed as if closed.

Worked example. A trader buys 2 ES contracts on November 10 at 5,000. On December 31, ES settles at 5,080. The contract multiplier is $50 per point.

• Unrealized gain: 80 points × $50 × 2 = $8,000.
• Even though nothing was sold, $8,000 goes on this year's Form 6781, split 60/40.
• On January 1 the basis for tax purposes is 5,080.
• If the trader sells on January 15 at 5,060, next year shows a loss of 20 × $50 × 2 = $1,000, not a gain of $6,000.

Most futures brokers do this arithmetic for you; the year-end 1099-B section for regulated futures contracts shows "profit or loss realized in current year", "unrealized profit or loss on open contracts at end of prior year", "unrealized profit or loss on open contracts at end of current year", and an aggregate that combines them. Your job is to copy the aggregate to Form 6781 and make sure the prior-year unrealized figure matches what you reported last year.

Two consequences:

• You can owe tax on a futures position you have not closed and may still lose money on in January.
• Holding a loser across year end does not defer anything; the loss is recognized at December 31 whether you like it or not.

Timing games with 1256 contracts are therefore nearly impossible, which, combined with the absence of wash sales, makes them the simplest instruments to report.

The straddle rules, briefly

Section 1092 targets offsetting positions: holding two positions in actively traded property where a loss in one is substantially offset by a gain in the other. Long stock plus a deep in-the-money put, long and short the same futures month in related contracts, long one ETF and short a near-identical one.

Without the rule, a trader could open both sides in December, close the losing leg for a deductible loss, keep the winning leg unrealized into next year, and repeat annually. The rules stop this three ways:

1. Loss deferral. A loss on one leg of a straddle is deductible only to the extent it exceeds the unrecognized gain on the offsetting leg at year end. The excess is carried forward.
2. Holding period suspension. While a straddle is open, the holding period of the legs does not run, and a leg held short-term when the straddle was formed stays short-term.
3. Interest and carrying charges allocable to the straddle are capitalized rather than deducted.

Example. On December 1 a trader is long 200 shares at $50 and buys two $60 puts (deep in the money) for $12 each. On December 28 the stock is $46. The puts are worth about $14.50; the shares carry a $800 loss. The trader sells the shares.

• Loss on shares: $800.
• Unrecognized gain on the puts: ($14.50 − $12) × 200 = $500.
• Deductible this year: $800 − $500 = $300. The remaining $500 is deferred until the puts are closed.

Special cases: a qualified covered call (not deep in the money, more than 30 days to expiry, written against stock you hold) is exempt from the straddle rules, though a deep in-the-money covered call can still suspend or reset the holding period on the stock. Mixed straddles (one leg a 1256 contract, one not) have their own elections, and a plain long-only position paired with an index hedge is normally not a straddle because a broad index is not "substantially similar or related" to one stock.

For most retail traders the practical exposure is small: single-leg trades, simple spreads closed together, and covered calls that are not deep in the money seldom trigger the rules. Multi-leg positions held across year end with one leg closed and the other open are where a CPA earns their fee.

Key idea: 1256 contracts are marked to market on December 31, so open futures and index options are taxed as if closed. Separately, the straddle rules defer a loss on one leg of an offsetting pair until the gain on the other leg is recognized.

Try it: Look at your open positions today. Mark any 1256 contract and estimate its unrealized P&L; that number would go straight onto this year's return if today were December 31. Then mark any pair of positions that offset each other and ask whether you would be closing only the loser at year end.

Recap

• Open 1256 contracts are treated as sold at fair value on December 31; basis resets on January 1.
• The broker's year-end statement reports realized, prior-year unrealized, current-year unrealized and the aggregate for Form 6781.
• Mark-to-market plus no wash sales makes futures reporting simple but removes loss deferral.
• The straddle rules defer a loss on one leg to the extent of unrecognized gain on the offsetting leg and suspend the holding period.
• Qualified covered calls are exempt; deep in-the-money hedges across year end are the typical trigger.