Two, Two, Two Taxes in OneThe first key to understanding SSFs is recognizing that they're securities as well as futures. Unlike conventional securities, however, they have expiration cycles, uses for hedging and forward-pricing purposes, and a "basis," or premium/discount to the price of the underlying stock. These attributes of futures have their own tax treatments, and they required changes to the existing tax laws for dealers, market makers and futures traders.
Taxes Create RiskLet's take two transactions that produce the same economic gain:
- Buy a stock at $35, watch it rise to $45, and sell an SSF at $45. If the stock continues rising, say to $50, you buy the SSF back at a $5 loss that can be used to offset gains elsewhere, up to the $3,000 limit. The unrealized capital gain on the stock of $15 remains untaxed and at risk. Economically, the pretax net gain is $15 minus $5, or $10. Buy a stock at $35, watch it rise to $45, and sell an SSF at $45. Then deliver the stock against the future at $45. You now have a realized short-term capital gain of $10, taxable at your ordinary income rate, but no further risk on stock.
Terrain Determines TacticsFor non-dealers, including just about all individual traders, Section 1234 of the tax code calls for SSFs to be taxed as capital gains. While any long position in a SSF held more than a year (only Nasdaq Liffe Markets has a fifth-quarter contract) will receive long-term capital gain treatment, all short positions will be taxed at the short-term rate. Why? The tax code wants to reward investors, not traders, and the thinking is that a short position cannot be an investment.
The Big 'Huh?'And now, like the Rolling Stones' "Honky Tonk Woman," here's something to blow your mind. Under Section 1259, the sale of an SSF against the underlying stock constitutes a constructive sale unless it comes under these two requirements for a short-term hedging exemption:
- The hedge must be closed before the 30th day after the close of the taxable year, which will be Jan. 30 for most of us; and For 60 days after closing the hedge, the underlying stock cannot be sold, nor can a trader put on a new hedge.