This article is featured in the KROST Industry Financial Services Magazine Volume 5, Issue 1, titled “Section 1256 Contracts and Straddles: A Guide to Tax Planning and Risk Management” by Matthew Weber, CPA.

Investing and trading in the financial markets can be a complex endeavor, and it is essential to consider several factors, including tax implications. Section 1256 of the Internal Revenue Code (IRC) addresses the taxation of certain derivative contracts, commonly known as Section 1256 contracts. Additionally, straddles, which involve offsetting positions in different securities or contracts, can have unique tax consequences. In this article, we will explore Section 1256 contracts and straddles, their definitions, and the tax treatment associated with them.


Section 1256 of the IRC defines specific types of derivative contracts that are subject to special tax rules. These contracts include regulated futures contracts, foreign currency contracts, non-equity options, and dealer equity options.

Let us delve into each of these contract types:


    These are standardized contracts traded on exchanges, such as futures contracts on commodities, stock indices, and interest rates. Taxation of regulated futures contracts is straightforward, as they are markedto- market at the end of each tax year. This means that gains and losses are treated as if the contracts were sold and repurchased at fair market value on the last trading day of the year.


    Currency contracts, commonly known as forex contracts, are also included under Section 1256. Similar to regulated futures contracts, gains and losses on foreign currency contracts are treated as if they were sold and repurchased at fair market value at the end of the tax year.


    Non-equity options, such as options on commodities or indexes, are another category of Section 1256 contracts. These options are subject to the mark-to-market treatment, where gains and losses are realized annually, regardless of whether the option is exercised.


    Dealer equity options refer to options on individual stocks that are actively traded. The tax treatment of dealer equity options differs from the other Section 1256 contracts. Gains and losses on dealer equity options are not marked-to-market annually but are treated as capital gains or losses when the options are closed or expire.


The unique tax treatment of Section 1256 contracts offers several advantages to traders and investors. The gains and losses from these contracts are treated as 60% long-term capital gains and 40% short-term capital gains, regardless of the holding period. This blended tax rate, known as the 60/40 rule, provides more favorable tax treatment for traders compared to ordinary income tax rates.

One notable benefit of 1256 contracts are the ability to carry back net losses up to three years. This provision allows traders to offset gains from previous years, potentially resulting in significant tax savings. It is important to note that this carryback feature is not available for straddle losses.

Moreover, traders in Section 1256 contracts have the option to elect out of the mark-to-market treatment. By doing so, they can defer recognition of gains and losses until the contracts are closed or expired. This flexibility allows traders to align their tax liabilities with their trading strategies and optimize their tax positions.


A straddle is an investment strategy involving offsetting positions in different securities or contracts to profit from price volatility. While straddles can be used in various markets, including stocks and options, their tax implications are primarily associated with options.

For tax purposes, a straddle occurs when an individual holds offsetting positions in identical or similar positions. A straddle can be either a long straddle, involving the purchase of both a call option and a put option, or a short straddle, where both options are sold.

The IRS has specific rules regarding the taxation of straddles. If a taxpayer holds a straddle, any loss on the position is deferred until the straddle is closed or expires. The deferred loss is added to the basis of the position that remains open. This rule prevents taxpayers from recognizing a loss in one year while deferring the gain to a subsequent year. In other words, a taxpayer must defer the loss into a gain recognition year.


Traders and investors can strategically incorporate Section 1256 contracts and straddles into their portfolios to optimize tax outcomes. By understanding the blended tax rate and loss carryback provisions of Section 1256 contracts, traders can structure their investments to maximize long-term capital gains treatment and potentially offset gains from previous years. It is also important to carefully manage straddle positions to navigate the tax implications effectively.


Straddles offers a way to manage risk and volatility in a portfolio. By holding offsetting positions, investors can hedge against adverse price movements or take advantage of anticipated market fluctuations. Careful consideration of the tax implications and regulations surrounding straddles is essential for effective risk management.

Navigating the world of Section 1256 contracts and straddles requires a solid understanding of their tax implications and the regulatory landscape. These financial instruments offer opportunities for tax planning, risk management, and potentially enhanced returns. However, it is crucial for traders and investors to carefully comply with tax rules and consult with experienced tax advisors, like the professionals at KROST.

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KROST Industry Magazine is a digital publication that highlights some of the hot topics in the accounting and finance industry. Volume 5, Issue 1 highlights some of the hot topics in Financial Services including the Silicon Valley Bank collapse, Section 1244, Section 1256, virtual currency, and more.