The recently enacted financial reform package (the “2010 Financial Regulation Act”) amends Code Sec. 1256 to broaden the list of contracts that are excepted from the definition of Section 1256 contracts and thus are excepted from mark-to-market treatment. Here are the details.

Section 1256 contracts are investments that fall under Code Sec. 1256, namely, any regulated futures contract, foreign currency contract, nonequity option, dealer equity option, and dealer securities futures contract. Section 1256 contracts are treated differently from other securities for tax purposes in that they must be marked to market at year end. Each Section 1256 contract held by a taxpayer is treated as if it were sold for fair market value on the last business day of the year. Any capital gain or loss on a Section 1256 contract that is marked-to-market is treated as if 40% of the gain or loss is short-term capital gain or loss, and as if 60% of the gain or loss is long-term capital gain or loss This tax treatment creates a unique trade-off because, on the one hand, it subjects the holder of the Section 1256 contract to capital gains taxes even though the position is still open, but on the other hand it permits Section 1256 contracts to qualify for long-term capital gains treatment even though most futures contracts are traded in a much shorter time frame than the 12-month rule required by the IRS for long-term capital gains treatment.

For tax years beginning after the enactment date, the 2010 Financial Regulation Act provides that all of the following are excepted from the definition of a Section 1256 contract: any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement. The Conference Report explains that the change addresses the recharacterization of income as a result of increased exchange-trading of derivative contracts by clarifying that Code Sec. 1256 does not apply to certain derivatives contracts transacted on exchanges.

We hope this information is helpful. If you would like more details about any aspect of the new legislation, please do not hesitate to contact us.