Tax Treatment of Securities Transactions

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This short primer will focus on two specific types of securities transactions which receive Mark to Market (MTM) Treatment.

As a refresher, mark to market (“MTM”) tax treatment is when gain or loss on open positions are realized at the end of the period as if they were sold. While MTM treatment typically requires a specific election to be made, certain types of transactions are required to have MTM treatment. So-called Section 1256 contracts which include certain foreign currency contracts, (which can also be ”Section 988” transactions), certain regulated futures contracts and non-equity options are transaction for which MTM tax treatment is mandatory.

Section 988 gets invoked when dealing with realized gains or losses on investments held in a foreign currency. The most common types of these transactions are foreign exchange positions, foreign currency futures & forwards, and international bonds among others. Section 988 does not apply to all foreign transactions. For example, buying a foreign stock would still be a capital transaction. However the foreign currency used to effectuate the transaction may be scoped into Section 988 as it is converted to / from U.S. dollars.

Gains or losses under Section 988 are treated as ordinary income or loss for tax purposes and will be taxed at the taxpayer’s marginal tax rate as opposed to the favorable rates for long term capital gains unless an election is made. This election, which must be submitted to the IRS, will identify each Section 988 transaction before the close of the day on which such transaction is entered into. A separate election is to be made for each transaction entered into. An election can be made to move the 988 transaction into the MTM taxation of Section 1256. Such elections thereby affect both character and timing.

Section 1256 positions can include regulated futures contracts, foreign currency contracts, listed non-equity options (e.g., index options), and commodity futures contracts. These positions are marked to market at year end and gain or loss is recognized as if the position was actually sold. However, unlike Section 988 transactions they are not taxed at ordinary rates. Instead they are split,60% long term capital and 40% short term capital regardless of the actual holding period. When preparing a K-1 or tax return these amounts have their own specific line so they are not to be included with general capital gains or losses. Form 6781 will need to be filled out and included with your return when Section 1256 is present.

Both of these items require detailed review of transactions and an understanding of the inevitable exceptions and alternatives under the tax code. The Financial Services Team at Withum is available to assist you in understanding the implications of the transactions.

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To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

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