Section 1256 contracts are named after the Internal Revenue Code section that governs them. Section 1256 aims to prevent tax-motivated straddles that would:

• Defer income
• Convert short-term capital gains into long-term capital gains

To prevent either from happening, Section 1256 requires that these contracts be traded in a mark-to-market exchange. So, if you hold Section 1256 contracts at the end of the year, they’re treated as if they were sold at their fair market value on the last business day of the year. This applies even though you still owned the contracts.

Gains and losses that result from the open contracts are recorded as 60% long-term and 40% short-term. This applies no matter how long you held the contracts. When you later dispose of the Section 1256 contract, the gain or loss is adjusted for the previously recognized gain or loss.

Section 1256 contracts are:

• Regulated futures contracts, like commodities futures
• Foreign-currency contracts that are publicly traded
• Nonequity options
• Dealer-equity options
• Dealer securities futures contracts

Use Form 6781, Part I to report the gains and losses on open Section 1256 contracts.

A straddle is when you hold contracts that offset the risk of loss from each other. You might realize a loss when you sell part of a straddle position. If so, your loss will be limited to the amount of any unrecognized gain in the offsetting position. Any loss you can’t currently deduct is carried forward to the next tax year. Straddle-loss rules and exceptions are quite complicated.

To learn more on reporting straddle losses, see:

• IRS Form 6781 instructions
• IRS Publication 550: Investment Income and Expenses