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Are Positions in Virtual Currency Subject to the Timing and Character Rules of Section 1256? If so, When and What is the Impact?

Author: Nicholas C. Mowbray a tax attorney, BakerHostetler.1

This communication does not constitute legal advice or an opinion of BakerHostetler. The views expressed in this  article are those of the author.

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The differences between holding a virtual currency position and a 1256 contract are significant. The former is subject to tax when it is sold or exchanged, with the gains and losses  constituting either long-term capital gains, short-term capital gains or ordinary income.2 The  latter are subject to (amongst other items discussed below) a mark-to-market method of  accounting, thus taking into income as a gain or loss the amount that would otherwise be  recognized if the 1256 contract were sold for its fair market value on the last business day of the  taxable year.  

The U.S. federal income tax rules define five types of financial products as “Section 1256  Contracts.” Currently however, only Bitcoin futures and options contracts constitute Section  1256 Contracts, and thus only two of these five products are applicable to virtual currencies.3 Nevertheless, the Commodities Futures Trading Commission (“CFTC”) has indicated that other  virtual currencies (in particular, Ethereum) may constitute commodities and, in addition, that the  CFTC anticipates that additional virtual currency derivatives will be traded on the U.S. markets  in the near future.4 Thus, while currently limited, the rules discussed herein will become more  applicable as the offering of derivatives for virtual currencies expands. The remainder of this  article discusses the special U.S. federal income tax rules that apply to Section 1256 Contracts.

Definition of a Section 1256 Contract

The five products that constitute Section 1256 Contracts include: 1) regulated futures  contracts, 2) nonequity options, 3) dealer equity options, 4) dealer securities futures contracts,  and 5) foreign currency contracts.5

Regulated Futures Contracts and Nonequity Options

A regulated futures contract is a contract traded on a qualified board or exchange that is  marked to market on a daily basis to determine the amount the taxpayer must deposit to its  margin account to cover losses, or the amount that it may withdraw from that account as a result  of gains.6 A non-equity option is an option (other than an “equity” option) that is traded on or  subject to the rules of a “qualified board or exchange.”7

A qualified board or exchange includes: a) a national securities exchange registered with  the Securities Exchange Commission (“SEC”); b) a domestic board of trade designated as a  contract market by the CFTC; or c) any other exchange, board of trade, or other market that the  IRS determines has rules adequate to carry out the purposes of Section 1256.8 Thus, while the  definitions of a regulated futures contract and a nonequity option differ significantly, they both  require establishing that the product is traded on a qualified board or exchange, which should  generally be met for trading on a domestic security exchange or commodities exchange, and may  be met by a non-domestic exchange identified by an IRS publication.9

Special Treatment Under Section 1256

The rules applicable to Section 1256 Contracts are not elective. Thus, with limited  exceptions, a Section 1256 Contract is subject to: 1) a mark-to-market regime (which overrides a  taxpayer’s ordinary method of tax accounting); and 2) a 60/40 long-term/short-term capital  gain/loss split. 

Mark-to-Market Rule

As noted above, the mark-to-market rule requires the holder of a Section 1256 Contract  to take into income as a gain or loss the amount that would otherwise be recognized if the 1256  contract were sold for its fair market value on the last business day of its taxable year. If a  Section 1256 Contract is closed out or disposed of before year-end, the close-out price is used to  determine the amount of gain or loss.10

A taxpayer that reports a mark-to-market gain or loss on a Section 1256 Contract  accordingly adjusts its basis in the Section 1256 Contract based on the amount of gain or loss  realized from the mark.11 Thus, a taxpayer holding a Section 1256 Contract may suffer the  burden of having a year-end tax liability despite not having disposed of and received cash for a  position. In addition, a taxpayer may suffer a loss on a disposition in a later year despite  receiving cash from the disposition.  

60/40 Treatment

60/40 treatment refers to the character of income a taxpayer recognizes from buying and  selling Section 1256 Contracts, that is 60 percent of the gain/loss is long-term, and 40 percent of  the gain/loss is short-term.12 The rule applies regardless of a taxpayer’s holding period.

Exceptions

As noted above, the special treatment applicable to Section 1256 Contracts is not  elective. Nevertheless, there are exceptions to this treatment where, for instance: 1) the taxpayer  holds a Section 1256 Contract and an offsetting position in an actively traded personal property (that is, a straddle);13 and 2) a taxpayer elects to be a commodities dealer. The former of these  may impact the ability of a taxpayer to defer gains and accelerate losses, while the latter impacts  a taxpayer’s ability to claim 60/40 capital gains treatment.  

Conclusion

Absent qualifying as a Section 1256 Contract, a virtual currency is not subject to these  rules. Taxpayers trading in derivatives of virtual currencies, however, should keep the rules  noted above in mind, and carefully analyze them as the number of derivative products applicable  to virtual currencies continues to increase.

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1 © Baker & Hostetler LLP. Nicholas C. Mowbray is a tax attorney at the law firm of BakerHostetler. This  communication may be considered advertising under the rules regulating the legal profession.

2 See BakerHostetler’s Memorandum on the tax significance of distinguishing between a dealer, trader, or investor  in virtual currency  

3 The Chicago Mercantile Exchange (“CME”) announced in early 2020 that it would launch options on Bitcoin  futures. https://www.cmegroup.com/cme-group-futures-exchange/options-bitcoin-futures.html

4 https://www.cftc.gov/PressRoom/PressReleases/8051-19

5 I.R.C. § 1256(b)(1). This article does not define dealer equity options, dealer securities future contracts, and  foreign currency contracts as they are not currently applicable to virtual currencies.

6 I.R.C. § 1256(g)(1).

7I.R.C. § 1256(g)(3).

8 I.R.C. § 1256(g)(7).

9 This is because these exchanges are either regulated by the SEC or CFTC. If a product is traded on a non-domestic  exchange, the list of exchanges published by the IRS should be reviewed to determine whether they satisfy the  definition of a qualified board or exchange.

10 I.R.C. § 1256(c)(1).

11 I.R.C. § 1256(a)(2).

12 I.R.C. § 1256(a)(3).

13 I.R.C. § 1256(a)(4).

This communication does not constitute legal advice or an opinion of BakerHostetler. The views expressed in this  article are those of the author.

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