Author: Andrea S. Kramer, McDermott Will & Emery*
The discussion in this document reflect legal principles as of February 29, 2020.
Taxpayers often enter into offsetting long and short transactions to minimize risk, defer tax, and convert long-term and short-term capital gain and loss to maximize the possible benefits of tax rate differentials. Particularly onerous tax consequences can result if taxpayers enter into offsetting positions where one— but not all—of the positions making up a straddle are taxed as section 1256 contracts while another offsetting position is not a section 1256 contract. Taxpayers who enter into certain virtual currency transactions can be subject to the adverse consequences of holding mixed straddles and need to understand ways they can minimize or avoid these consequences.
Taxpayers who do nothing—whether intentionally or inadvertently—are subject to the “killer rule,” which applies to convert short-term loss from a non-section 1256 position to 60/40 loss.1 Short-term gain offset by 60/40 losses are left unchanged. The killer rule “converts” only one way—in the government’s favor—and it is a “killer” to any taxpayer with a substantial volume of mixed straddles.2 This one-way conversion typically has a punitive tax effect.
Taxpayers who hold positions in Bitcoins and Bitcoin futures or options traded on the Chicago Mercantile Exchange (CME) can be subject to the mixed straddle rules if they hold straddles where not all of the positions are in CME futures or options. For background reading on the straddle rules and section 1256 treatment, see McDermott’s Memoranda, “When Virtual Currency Positions are Subject to the Straddle Rules” and “Special Tax Rules Apply to Bitcoin Futures and Options and Might Apply to Positions in Other Virtual Currencies in the Future.” This Memorandum discusses the tax rules for mixed straddles, that is, straddles that consist of both section 1256 contracts and non-section 1256 contracts.
Overview of Straddle Rules
A tax straddle exists when a taxpayer holds two or more positions in personal property when one or more of the positions substantially diminishes the risk of loss with respect to another position.3 Virtual currency positions are subject to the tax straddle rules if the virtual currency is actively traded personal property and the positions are offsetting.4 The straddle rules require deferral of losses on an offsetting position until the gain positions are closed out.
Convertible virtual currency is “property” for tax purposes, and the IRS applies general tax principles to transactions in virtual currency.5 Because Bitcoins have an equivalent value in actual currency, can be substituted for actual currency, are traded on an established on-line market, and can be purchased for or exchanged into U.S. dollars or other actual or virtual currencies, it is likely that Bitcoins are subject to the straddle rules.
A tax straddle is a mixed straddle if one or more of the positions in the straddle is a section 1256 contract and the other positions are not section 1256 contracts.6 If a taxpayer holds CME Bitcoin futures or options as well as other Bitcoin positions, the taxpayer probably holds a tax straddles that may be subject to the mixed straddle rules. Because section 1256 contracts are subject to 60/40 tax treatment while non-section 1256 positions are subject to short-term capital gain or loss, taxpayers could have an incentive to use mixed straddles to convert short-term capital gain into 60/40 gain. Congress enacted the mixed straddle rules to prevent such a tax conversion.
Why Special Rules Were Needed
In the absence of the mixed straddle rules, taxpayers could generate short-term loss in a non-section 1256 contract position and an offsetting 60/40 gain in a section 1256 contract. The short-term loss could then be used to mop-up unrelated short-term gain (leaving the taxpayer with only long-term capital gain). The mixed straddle rules prevent taxpayers from doing this. They also prevent taxpayers from reporting 60/40 gain or loss on section 1256 contracts and (depending on the taxpayer’s holding period) 100 percent short-term or long-term capital gain or loss on their non-section 1256 positions.7
Choices Available When Holding A Mixed Straddle
Taxpayers with mixed straddles essentially have four choices if they want to avoid the killer rule:
- Elect Out of I.R.C. § 1256. A taxpayer can make a one-time section 1256(d) identified mixed straddle election that removes the section 1256 contracts in the straddle from section 1256 treatment. The mixed straddle remains subject to the straddle rules, and if the taxpayer does not properly identify all of the positions making up the mixed straddle, special rules convert short-term capital loss to 60/40 loss when offset by a 60/40 gain. Interest and carrying charges incurred to carry a mixed straddle position must also be capitalized.