With tax day right around the corner, we want to remind investors that tax treatment of most Commodity Futures Trading Commission (CFTC) regulated products is different from that of stocks, stock options and other, more traditional investments.
Gains and losses in futures and futures options are taxed at a 60% long-term rate and 40% short-term rate no matter what the holding period. It could be one hour, one day or one year; the 60/40 formula applies across the board. This treatment currently applies to both futures accounts managed by Commodity Trading Advisors (CTAs) as well as those held by hedgers or individual speculators.
This means $600 of a $1,000 gain in futures or futures options will be taxed as a long-term capital gain. $400 of that gain will be taxed as a short-term gain. Losses are treated the same way. Assuming a loss of $1,000, $600 will be treated as a long-term capital loss and $400 will be treated as a short-term capital loss.
Because this formula is so simple, investors do not need to keep detailed records of every trade. Your brokerage house or clearing firm takes care of that for you. You get a form showing two numbers: your total long-term capital gain or loss and your short-term capital gain or loss. You or your accountant plugs these into your return and you are done, unlike stock and stock option accounts in which every trade needs to be documented.
No Cost Basis Worries
If you have ever tried to find the cost basis of a non-covered security that you have sold after you've been holding for years, you know what a tremendous time sink this can be when preparing your return. Traditional stock brokerage firms are only required to supply you with cost basis information going back seven years, which can mean hours of sifting through old paper records. This does not happen with individually managed futures accounts or with futures and futures options accounts in general.
Individual and managed futures accounts are "marked to the market" for tax purposes. This means that all gains or losses are realized at the end of the calendar year whether or not the positions in the account have been sold.
Let's say an investor opens an account for $100,000 at any time in 2016 and as of market close on December 31st of 2016, it is worth $110,000. The $10,000 gain is taxable even if none of the positions in the account have been sold. $6,000 would be taxed as a long-term capital gain and $4,000 would receive short-term capital gain treatment. In this case, $110,000 becomes the investor's new tax basis for 2017. On the other hand, a $10,000 loss in 2017 would result in a new tax basis of $90,000 and the 60/40 rule would apply to capital losses as well.
Why is the tax treatment of futures? Because futures and futures options are used to hedge. A hedger is someone or some entity that uses the futures market to control costs, not as a forum for speculative money-making. For example, an airline looking to lower the future cost of aviation fuel may try to lock in today's low cost by buying diesel fuel or heating oil future contracts or call options on those contracts. If the price of jet fuel rises, gains in these contracts help to offset increases in the airline's future cost of fuel.
Making this hedge allows the airline to "store" fuel without having to build huge tank farms. It makes sense that this transaction would be treated differently than someone buying heating oil futures or call option contracts with expectation to sell them later for a profit. However, it can be very difficult to separate legitimate hedging transactions from speculative transactions in today's trading environment. To cover all the bases, a compromise was made and today's 60/40 tax treatment - applying to nearly all futures and futures options transactions - was agreed to.
Futures Tax Treatment a Potential Plus for Traders And a Big Advantage over Many Hedge Funds
The 60/40 split treatment of futures and futures option can be a big advantage for traders and money managers with average holding periods of less than a year - especially when compared against the 100% short-term treatment of nearly every other asset class held less than a year. This is one of the big advantages individually managed futures accounts have over hedge funds. But it isn't the only one.
Here are a few more:
- Managed futures are more liquid than hedge funds. Individually, managed futures accounts are segregated and held in the account holder's name. Hedge funds commingle cash and trading positions with other investors. Unlike hedge funds, which can hold hard-to-sell swaps and forward contracts, managed futures mostly trade centrally cleared, futures and options contracts that can be entered and exited relatively easily and in many cases - nearly 24 hours of each trading day.
- Managed futures generally do not have "lock up" features. Most let you access your capital immediately. Managed futures account holders can close their account with a phone call and, can have their balances wired to them the next business day. They can also add funds to their accounts the same way. Hedge funds generally require bigger initial investments and have "lock up" provisions which can block access to capital for months at a time. "Lock ups" are extremely rare in managed futures.
- Managed futures generally have lower initial capital requirements ranging from as low as $15,000 to as high as $1 million and higher. Hedge fund capital requirements are usually much higher with many starting at $1 million.
- Managed futures are not correlated to hedge funds. Most hedge funds are positively correlated to the stock market and tend to underperform during periods of stock market weakness. Managed futures are not correlated to stocks, bonds or hedge funds, making them extremely effective diversification tools.
- Disclosure and transparency. Managed futures investors get a statement via regular mail and/or e-mail each and every time a move is made in the account. Hedge funds only supply monthly, and in many cases, just quarterly statements.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The risk of loss in trading futures and/or options is substantial and each investor and/or trader must consider whether this is a suitable investment. Past performance, whether actual or indicated by simulated historical tests of strategies, is not indicative of future results.