By Jim Forrester, CPA
Futures trading covers a vast array of trading instruments, from stock indices and U.S. Treasury bonds to precious metals, energy sources such as oil and gas, and everyday foodstuffs including meats, grains and coffee.
Some futures traders buy and sell futures contracts to establish a current price of a purchase or sale to take place at a later date, thus providing a hedge against adverse price changes. Others speculate by buying or selling based on where they expect the market to go in order to profit from the very movements the hedgers seek to avoid.
When tax time rolls around however, the Internal Revenue Service groups each of your futures trades into one of two categories: securities or commodities. The biggest difference: commodities enjoy a lower tax rate.
While it may seem commonsensical to figure out which class your trades best fit, the number of new hybrid financial products created with the passage of the Commodities Futures Modernization Act of 2000 (CFMA) effectively blurred the distinction between some securities and commodities, at least for tax purposes.
The CFMA expanded the definition of a “broad-based index” (10 or more securities) to include almost all futures and options on stock indices, including “e-minis,” treating them as commodities and favoring them with a tax break. “Narrow-based” indices (nine or fewer securities), by contrast, are considered securities and taxed at the ordinary capital gains rate.
Securities vs. Commodities
Securities futures capital gains/losses are reported either on Schedule D (Capital Gains and Losses) or as ordinary capital gains/losses on IRS Form 4797 Part II (Sales of Business Property) if you elected mark-to-market accounting. Your securities trades are taxed as short-term capital gains at the ordinary income tax rate of up to 35%.
Commodities futures capital gains/losses are reported on Form 6781 (Section 1256 Contracts), which qualifies these for an advantageous tax split: 60% at the long-term rate of 15% and 40% at the ordinary short-term rate of up to 35%, or a combined rate of 23%, for a tax savings of 12%.
Because of this attractive 60/40 split, most commodities traders forego mark-to-market accounting and its favorable “loss insurance” in order to reap the benefits of the lower capital gains rate.
The Exception: Single-Stock Futures
What would IRS regulations be without an exception or two, right? In the case of futures, that exception affects single-stock futures, or SSFs, also referred to as securities futures contracts.
The IRS lumps SSFs in with securities and taxes them on the same basis as their underlying stocks, options or narrow-based indices. As a result, you pay the short-term capital gain rate of 35% on single-stock futures, and not the lower rate the IRS affords to commodities futures.
To make matters more confusing, the IRS doesn’t require your broker to report SSF proceeds on your IRS Form 1099-B, which lists proceeds from stock sales. While your broker or brokers may choose to include this information on your 1099-B, if they don’t, it can be a headache to break them out, especially under the crunch of tax deadline.
Futures traders have been given a considerable tax break in recent years that reflects the changing and expanding nature of the various financial products available. But if you don’t report correctly, you may join the majority of traders who routinely overpay to the IRS. Before filing this year, contact a Traders Accounting tax professional. We can help you sort out your activity and file a complete return that fully complies with IRS guidelines while achieving maximum tax advantages.
Take it from experienced traders: don’t go it alone when it comes to filing with the IRS. One false move can cost you plenty, possibly even your trader tax status. We strongly recommend you seek the assistance of a trader tax professional at Traders Accounting this tax season.