What is the status of the tax treatment of futures under the new law? Are they still eligible for 60/40 treatment (part long-term capital gain and part short-term capital gain)?
Your question touches on an issue still being debated by tax professionals. In short, the new law doesn't address the tax treatment of futures at all. But some pros wonder if futures contracts will be an allowable exception to the holding period required for dividend-paying stocks.
First, a refresher on the holding-period rules: Typically, investors in dividend-paying stocks must hold the stock until a specified date in order to receive the upcoming dividend payment. Now, under the new tax law, investors must hold the stock for more than 60 days during the 120-day period that begins 60 days before the ex-dividend date (the first trading day after the eligibility date). If an investor or a fund manager owns the stock for 60 days or less during the two months before and after the ex-dividend date, all dividends will constitute ordinary income and will be taxed at the investor's ordinary income-tax rate.
But the issue of futures isn't mentioned specifically in the new tax law. "The law itself ignores the issue," says Mark Luscombe, a tax attorney with CCH, a tax law research firm. "But people are hoping that the Treasury or IRS will discuss how the rules regarding the holding period relate to short sales and hedging transactions such as futures contracts."
Prior to the 1997 tax law, investors could "lock in" gains on securities without actually selling and incurring capital gains tax by using a variety of hedging strategies -- including short sales, forward and futures contracts. Now, though, such hedging tactics are considered a "constructive sale" -- and that means that investors need to recognize the gain (and pay the tax) as of the date the constructive sale took place. It's as if the securities were actually sold, and the holding period on the security is terminated.
Now the thorny part: One exception to the constructive sale rule is if the hedging strategy is actually used to reduce risk -- and isn't a tax-avoidance scheme. So a futures contract taken during the required 60-day holding period may be a legitimate exception, allowing investors to have their dividends taxed at the 15% rate. But if the futures contract is taken out to lock in a gain for tax-avoidance purposes, it likely will trigger the constructive sale rule, which means the stock will be considered sold for tax purposes, and any related dividends will likely be taxed at the taxpayer's ordinary income-tax rate -- and
the low 15% rate.
But as for taxing the futures contracts themselves, the tax law is pretty clear. Taxpayers should use the mark-to-market method of accounting for all futures contracts traded on regulated U.S. exchanges. Marking transactions to market is a method of accounting in which any gains or losses on existing positions are reported as if sold on the last day of the year, even if the trader doesn't actually sell them. To do this, you must classify yourself with the Internal Revenue Service as a trader, not an investor. (For more on this distinction, see
Sour Stocks Are More Taxing on Investors Than Traders.)
Generally, positions in regulated futures contracts using the mark-to-market system are treated as if they were sold on the last day of the year. Any capital gains or losses are arbitrarily allocated -- 40% of the amount is treated (and taxed) as a short-term; 60% is long term.
Futures contracts that are sold before the end of the year, though, will be somewhat affected by the new tax law, Jonathan Schmeltz, a tax partner with Grant Thornton, notes. The new law, remember, lowered the long-term capital gains rate from 20% to 15% -- but only retroactive to May 6, 2003. (Click
here for an explanation as to how May 6 was chosen.) So any gain on a futures contract sold before May 6 will have 60% of it taxed at the 20% rate, while futures contracts sold on or after May 6 will have the 60% portion attributable to long-term gain taxed at the new 15% rate.