Stocks, Stock Options, Exchange Traded Funds (ETFs), and Options on ETFs:
These instruments are grouped together as their taxation is generally the same. The default rule is the gain or loss from trading these instruments is capital gain or loss. For tax purposes net capital losses are deductible up to $3,000 against other types of income such as wages, retirement distributions, interest, and dividends. Any net capital loss above the $3,000 is carried forward to future years where it is deductible at $3,000 unless offset by future capital gains.
The taxation of capital gains depends on how long the instrument is held prior to the sale. If the instrument is held for one year or less it is considered short term capital gain which is taxed at the taxpayer’s ordinary tax bracket. If the instrument that generated the gain was held for more than one year the gain is considered long term capital gain and taxed at a maximum of fifteen percent.
These are the general rules. There are some more complicated issues that have to be kept in mind regarding the taxation of these instruments. First, these instruments are subject to the wash sale rule. Next, ETFs that are composed of precious metals may be taxed as collectibles. Finally, the tax rates on long term capital gain are subject to change by congress.
Section 1256 Contracts:
There are several types of instruments that are governed under Section 1256. Some examples of 1256 contacts are futures, commodities, and broad based index options. The general rule for 1256 contracts is 60% of the gain or loss is considered long term capital gain or loss and 40% is considered short term capital gain or loss. This generally applies regardless of how long the position was actually open. Another component to the general rule is that any open 1256 positions are marked to market at the end of the year and the unrealized gain or loss is recognized on the tax return.
One special rule for 1256 contracts is losses can be carried back and applied to past gains. However, the loss can only be used to offset gain from 1256 contracts. Also wash sales do not apply to 1256 contracts.
In this discussion when we talk about foreign exchange we are referring to actually buying and selling currencies. Generally, foreign exchange is governed under Section 988. This section states that gain or loss from trading foreign currencies is ordinary income or loss. Since losses from foreign exchange are ordinary loss the losses can be used to offset income from other sources such as wages, interest, and dividends.
One special rule that can apply to foreign currency is that the trader can opt out of Section 988 treatment. Opting out of Section 988 makes the foreign currency trading subject to the rules of Section 1256. The election to opt out of Section 988 must be made before the trade is placed. Also, keep in mind that wash sales do not apply to foreign currency.
The information above should give you a better understanding of the general tax ramifications of different types of trading. However, as with all areas of the tax code there are many additional rules that need to be kept in mind. Therefore, it is highly recommend you speak to a qualified tax professional to obtain more information related to your specific type of trading.
By Adam Kelsey, EA and Christine Spiehs, CPA