Section 1256 Contracts
Section 1256 contracts are regulated futures contracts, foreign currency contracts, nonequity options, and dealer equity options subject to a special IRS tax rule requiring them to be marked to market at year-end as if sold, with gains and losses taxed under a mandatory 60/40 split: 60% treated as long-term capital gain or loss and 40% as short-term, regardless of the actual holding period.
Section 1256 of the Internal Revenue Code establishes a distinctive and investor-favorable tax regime for a specific set of financial instruments. The category covers regulated futures contracts traded on a designated contract market (such as CME-traded S&P 500 futures), foreign currency contracts, nonequity options (including broad-based index options like SPX options), and dealer equity options. Narrowly equity options on individual stocks do not qualify — they are taxed under the standard short-term/long-term capital gains rules.
The two key features of Section 1256 treatment are mark-to-market accounting and the 60/40 blended tax rate. Under mark-to-market, all open Section 1256 positions are treated as if sold at fair market value on December 31, forcing recognition of any unrealized gain or loss regardless of whether the position is closed. Gains and losses are then carried over to Form 6781 and allocated 60% to long-term capital gain/loss and 40% to short-term capital gain/loss.
The 60/40 split is blended at all income levels. For a taxpayer in the highest brackets in 2025 — 37% ordinary income rate and 20% long-term capital gains rate plus the 3.8% NIIT — the blended maximum rate on Section 1256 gains is approximately 26.8%, meaningfully lower than the 40.8% maximum applicable to short-term gains. Even for a position held only one day, the 60% long-term treatment applies.
Section 1256 losses receive similarly advantageous treatment: taxpayers may carry back net Section 1256 losses up to three years to offset Section 1256 gains recognized in those prior years, providing potential refund opportunities not available with other capital losses. Alternatively, losses can be carried forward. The carryback election is made on Form 1045 or by filing an amended return.
Broad-based index options (options on the S&P 500 Index, Nasdaq-100 Index, Russell 2000, etc.) are among the most commonly traded Section 1256 contracts by retail investors. Cash-settled options on these indices qualify; options on ETFs that track these indices (such as SPY or QQQ options) do not — they are treated as equity options taxed under the standard rules.
Section 1256 treatment cannot be elected or opted out of — it applies automatically to qualifying contracts. Brokerage firms are required to report Section 1256 contract activity on Form 1099-B or in a combined tax statement, and Form 6781 is used by taxpayers to report gains and losses from these contracts.