There are two sets of rules for taxation of options. One set, which might be called the regular rules, applies to options to buy or sell stock in a company. Different rules apply when options qualify as section 1256 contracts. Section 1256 of the Internal Revenue Code offers unique treatment for these options:
- Capital gain or loss is treated as 60% long-term and 40% short-term without regard to how long you held the option.
- Any positions you hold at the end of the year are marked to market, which means you report gain or loss based on their current value even though you haven’t sold them.
If you use options in your investment strategy, it may be important to know whether options to buy or sell shares in exchange-traded funds, or ETFs, are treated as regular options or section 1256 contracts. The answer: it depends.
Initially, ETFs were formed as corporations. This meant that options on those ETFs were options to buy or sell stock in a company, and would be taxed under the regular rules. More recently, many ETFs have been formed as trusts or partnerships. According to Twenty-First Securities, listed options (but not OTC options) on these ETFs may qualify as section 1256 contracts.
Note that section 1256 treatment is not always to your advantage. In particular, if you plan to hold options more than a year, you may wish to avoid that treatment, by using options on corporate ETFs or using OTC options, so that gain will not be taxed at year-end and treated as 40% short-term.
Reference
How Are Your ETF Options Taxed? (article on Twenty-First Securities website; includes link to a listing of ETFs classified according to whether options are regular or 1256)
