A Tax Rule That 'Sounds Too Good to Be True'

Does the Section 1256 60% long-term capital gains treatment apply to all options on the S&P 100 (OEX) or only open positions that are carried over into the new tax year? I trade OEX options quite often and it just sounds too good to be true that all of my OEX trades get 60% long-term capital gains treatment. What's my cost basis going forward?

-- James Fink

James,

First, I'm sorry we missed your question in last week's tax chat. (In the midst of our chat, we told James we'd get back to his question and never did!)

Second, the 60/40 rule applies to all securities that fall under Section 1256 of the tax code. It doesn't matter whether the positions are open at year-end or were sold midyear.

Section 1256 securities include regulated futures contracts, foreign currency contracts, options on stock index futures and broad-based stock indices, including the S&P 100. In addition, the tax code says that if any of these positions are open at year-end, they must be marked to market. "That means you treat those securities as if you sold them on the last trading day of the year and bought them right back," says Gail Winawer, a tax securities partner at American Express Tax & Business Services.

So any gains or losses at year-end are subject to the 60/40 rule -- 60% are long term and 40% are short term, regardless of the actual time you've held the securities.

Note that if you mark to market your open positions, you'll need to adjust their cost bases, says Richard Shapiro, an Ernst & Young securities tax partner in New York. If, for example, your bought an OEX call at 20 and it jumped to 22 at year-end, you will owe tax on that $2 gain. If your basis isn't readjusted to 22 and the option kept rising to say, 25, you'd owe tax on $5 if you closed the position. But you already paid tax on $2 of the gain, so you'd be paying too much without the adjustment in cost basis.

Check out this previous Tax Forum for more on the 60/40 rule.

Traders and Tax Software

I'm filing for trader status. I have capital gains and am using TurboTax Deluxe to file my tax return. How do you write the note "Section 475 election to Schedule C" next to the negative amount (to make the balance zero) on Schedule D, line 17? And, how do you write the note "Section 475 election from Schedule D" on Schedule C, line 1. I tried to input the note next to the number on those lines, but it only takes a number.

-- Norman Yap

Norman,

If you are working with a tax preparation software that will not allow you to insert that note, just print it out and write it in by hand. The drawback to printing out your return is that you can't file it electronically -- but this is the case for most traders. (An electronically filed Schedule D -- Capital Gains and Losses can't handle more than 194 trades.)

Since there's no box to check to alert the Internal Revenue Service that you're filing as a trader, the only way to prove to Uncle Sam is by the way you file. So here's a quick reminder of how to fill out Schedule D and Schedule C -- Profit or Loss From Business as a trader.

First, report all your gains and losses on Schedule D. That way, your gross proceeds from sales tie into your Form 1099s from your broker.

Then work through the form until you get to line 17 (total net gain) or line 18 (total net loss). At this point, you want to make the balance on Schedule D zero so you can transfer it to line 1 (gross receipts) on Schedule C. You need to do this zero calculation by hand on Schedule D. Then write "Section 475 election to Schedule C" next to that negative amount.

The tax preparation programs will not carry your number from Schedule D to line 1 of Schedule C, so you must override the amount in the system. Be sure to write "Section 475 election from Schedule D" next to line 1. Check out this story from our Taxes for Traders series for a visual example.

While I believe you should not override numbers when preparing your tax return, this is one of the very few exceptions to the rule.

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