QUESTION: How are 1256 contracts taxed? And how does Mark-to-Market affect them?
ANSWER: 60% of the gain or loss of a 1256 contract is treated as a long-term capital gain or loss and the other 40% is treated as a short-term capital gain or loss. This is regardless of the actual length of your holding period.
All indexes, such as 1256 contracts, are treated as Mark-to-Market. Typically, the mark-to-market treatment changes the nature of the income from capital to ordinary. However, in the case of 1256 contracts, it remains a capital gain or loss.
You have the choice of electing mark-to-market for your accounting method, and converting the tax treatment of your 1256 contracts to ordinary income (losses). The largest benefit is if you lose a lot of money trading. Then, the loss is considered ordinary and offsets other ordinary income you may have. With just an ordinary loss, the $3,000 capital loss limitation is also removed.
In general, taking the Mark-to-Market election would not be a good idea for someone who only traded 1256 contracts or index options because changing the capital gains to ordinary income would remove the benefit of the 60% – 40% split. However, the Mark-to-Market rule does allow you to treat some of your trading as Mark-to-Market and identify other positions as not Mark-to-Market. To do this you must identify those positions that you do not want to be Mark-to-Market with a note in your business records at the time of purchase.