For retirees seeking to limit taxes, Section 1256 contracts could be worth a look

  • By Nick Ravo,
  • Barron's
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Investors of all sizes have long sought out tax-advantaged products such as stocks paying qualified dividends and tax-free municipal bonds. One tax-friendly vehicle that doesn’t get much attention is the Section 1256 contract.

Named for its place in the Internal Revenue Service’s code, Section 1256 is most often associated with futures, but it also covers options on indexes such as the S&P 500 (.SPX), the Russell 2000 (.RUT), the Cboe Volatility Index (.VIX), and many tax experts believe cash-settled exchange-traded notes such as the popular iPath S&P 500 VIX Short-Term Futures ETN (VXX). They can allow investors to employ a number of investment strategies at favorable capital-gains rates.

Here’s how they work: Instead of applying the standard long- or short-term tax rates on capital gains, Section 1256 contracts are taxed at a blended rate of 60% of an investor’s long-term rate and 40% at the higher short-term rate.

At the current maximum tax bracket of 37%, the blended 60/40 rate is 26.8%—10.2 percentage points lower. In dollars, this amounts to an investor, effectively, paying $26,800 on $100,000 in short-term gains instead of $37,000. The savings can be even larger, in percentages, for those in some of the lower tax brackets.

Robert A. Green, a certified public accountant at GreenTraderTax.com, says the contract’s benefits are well known among professional and active traders, but also should be used by smaller investors, particularly retirees who are now trading their own accounts or allowing others to do so. “It’s definitely something worth considering because the tax benefits are so compelling,” he says.

Tactically, initiating trades in options contracts that qualify for Section 1256 tax treatment can resemble a kind of stock substitution with long-term options similar to what some investors often do to hedge high stock prices. For example, instead of trading 100 shares of S&P 500 options, an investor would buy or short S&P 500 Leaps contracts, which are options that expire in 12 to 28 months, with a combined delta of 1 or close. (Delta is the amount an option price is expected to move based on a $1 change in the underlying stock.)

Besides using Leaps, investors looking to use Section 1256 contracts can write puts or calls, or create spreads in indexes, to speculate or create income. Others may use strategies with futures—such as buying or selling popular e-mini S&P 500 contracts or the futures options that trade on them. (Note: Offsetting options or futures positions—buying and selling the same contracts—may be treated differently.)

Section 1256 contracts have another benefit: They allow a three-year carry-back election, which means that a current Section 1256 loss can be deducted from past Section 1256 gains by amending previous years’ taxes. Unused Section 1256 carryback losses carry forward to subsequent years.

What’s more, the contracts aren’t constrained by wash-sale rules because they are marked to market at the end of every trading day with both realized and unrealized gains or losses combined at year’s end on tax forms. (A wash sale occurs when an investor, their spouse or company they control, sells or trades a security at a loss, and within 30 days before or after, buys another one that is substantially identical.) The wash-sale rule prevents taxpayers from taking a capital loss and quickly buying back the position.

Annual tax preparation is easier with Section 1256 contracts: It uses summary reporting, unlike securities where you report each trade. Enter the “Aggregate profit or (loss) on contracts” amount from the 1099-B on Form 6781.

So, what’s not to like about Section 1256? How about its future?

For years, the provision has been on a list of potential tax loopholes Democrats wish to close, only to survive thanks to Republicans in Congress and lobbying by the futures industry. Any change in party control of the White House or Congress this coming election season could mean that the treatment would disappear.

Until that day comes, experts say Section 1256 remains a useful strategy.

“I have many retail trader tax clients who trade Section 1256 contracts,” says Al Davidson, an accountant with Pro Trader Tax in Denver. “They like trading Section 1256 contracts because of the ability to trade such diverse markets, the financial leverage offered, and the tax advantages.”

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