Non-Equity Options (Section 1256 Contracts)

Everything covered so far applies to equity options: options on individual stocks. Non-equity options on broad-based indexes, foreign currencies, and interest rates follow a completely different tax regime under the 60/40 marked-to-market rule of the Internal Revenue Code (IRC). The rules differ in ways that generally favor the taxpayer.

What Qualifies for 60/40 Marked-to-Market Treatment

The key test: Is the option based on a broad-based index (10 or more underlying securities), a foreign currency, or interest rates? If yes, it qualifies.

Exam Tip: Gotchas

• Individual equity options (e.g., IBM calls) do NOT qualify for the 60/40 marked-to-market regime. Only broad-based index options, foreign currency options, and yield-based options get the favorable 60/40 tax treatment.
• Narrow-based indexes do NOT qualify. The index must be broad-based (10+ underlying securities).
• If the question mentions "S&P 500 index option" or "broad-based index," think 60/40 marked-to-market. If it mentions a specific company name, it is an equity option with standard tax treatment.

The 60/40 Rule

All gains and losses on these non-equity contracts are taxed as:

• 60% long-term capital gain/loss
• 40% short-term capital gain/loss

This split applies regardless of actual holding period: even positions held for a single day get the 60/40 treatment.

Tax advantage: At the maximum federal tax bracket, the blended rate is approximately 26.8% compared to 37% for ordinary short-term rates. That saves over 10 percentage points on taxes for active traders of index options.

Example: A trader buys an S&P 500 index call, holds it for 3 days, and realizes a $10,000 gain.

• 60% ($6,000) taxed at long-term rate (currently 20% max)
• 40% ($4,000) taxed at short-term rate (currently 37% max)
• Blended tax = ($6,000 x 0.20) + ($4,000 x 0.37) = $1,200 + $1,480 = $2,680 (26.8%)
• If this were an equity option: $10,000 x 0.37 = $3,700 (37%)

Exam Tip: Gotchas

• The 60/40 split does NOT apply to equity options on individual stocks. It only applies to broad-based index options, foreign currency options, and yield-based options.
• Holding period does not matter. Even a position held for one day gets the 60/40 treatment for these non-equity contracts.

Mark-to-Market Rule

These non-equity contracts are marked to market at year-end:

• Open positions on December 31 are treated as if sold at fair market value on the last business day of the year
• Unrealized gains and losses are recognized for tax purposes
• The year-end fair market value becomes the new cost basis for the following year

Think of it this way: The IRS takes a snapshot of your marked-to-market positions on December 31. Even if you have not sold, any paper gains or losses in that snapshot count as taxable events for the year. Your cost basis resets to the snapshot value on January 1.

This means you cannot defer gains by holding positions open across tax years. The Internal Revenue Service (IRS) treats all such positions as if they were closed on December 31.

Example: You buy an S&P 500 index option in November for $5,000. On December 31, it is worth $8,000.

• You report a $3,000 gain for the current tax year (60/40 split)
• Your new cost basis entering January 1 is $8,000
• If you sell in January for $9,000, you report a $1,000 gain for the new tax year

Exam Tip: Gotchas

• Unrealized gains on December 31 ARE taxable for marked-to-market contracts. You cannot defer gains by holding positions open across tax years.

Loss Carryback

A unique benefit of these marked-to-market contracts:

• Net losses on these contracts may be carried back up to 3 prior tax years
• The carryback applies only against prior gains on the same type of contract in those years
• Reported on Form 6781 (the federal form for gains and losses on these marked-to-market contracts and straddles)

This is different from regular capital losses, which can only be carried forward (not back).

Exam Tip: Gotchas

• Losses on these contracts can be carried BACK up to 3 years. Regular capital losses can only be carried forward, never back.
• The carryback only applies against prior gains on the same type of marked-to-market contract, not against all capital gains.

60/40 Marked-to-Market Benefits Summary