With the calendar rolling over to April last week, it isÂ that time of year for taxpayers in America - one of Americaâ€™s least favorite days of the year: April 15th- tax day.
While the average American detests this day, investors surveying their gains and losses often abhor the date even more as they compile statements to find their cost basis and take a look at the taxes they owe. However, the pain endured in the payment of taxes can differ greatly, depending on the kinds of investments you hold. Turns out, if youâ€™ve invested in managed futures, you may be letting out a sigh of reliefâ€¦ unlike your stock investing counterparts.
Confused? Sit tight. Weâ€™re about to explain all of this.
What is different with futures tax accounting versus stocks?
Unlike stocks, futures based investments are based on their value at the end of the year, so any open trade profits or losses in the account are treated as realized profits or losses as of the last day of the year. In addition, futures based investments do not require the accounting of individual trades. This is a godsend for any of you who, like me, have spent hours searching through old brokerage statements from 4 years prior trying to find my cost basis for a certain stock.
Taxes on the security side are trade by trade based, and depend when you got into a certain investment and when you got out. Conversely, taxes on your futures based investments are only concerned with the gross profit or loss achieved using commodity futures contracts for the year. This is good news for investors who could be with an active CTA program or trading system which trades several hundred or thousands of times in a year.
While both stocks (securities) and futures are eventually recorded as investment income or losses, there are big differences between the two for the purposes of your tax return. These differences are often overlooked by the average investor, but can add up to real tax savings. Let us first look at the securities side of things, which includes stocks, mutual funds, and ETFs (such as the SPDRs and QQQs).
Gains on securities such as stocks are taxed at either the short term capital gains rate of up to 35% or the long term capital gains rate of 15%. To receive the long term capital gains treatment, the securities investment must be held for longer than one year. One important thing to remember is that you are not taxed on the gain from a security until you sell that security. Thus if you bought GE 10 years ago and have held it ever since, you haven’t paid any taxes on the gains of that investment, and won’t until you sell (GE is actually down over 40% since 2000). Conversely, if you are an active trader and bought and sold the QQQs a few times in 2010, you are responsible for taxes equaling 35% of the gains.
The taxation of commodities investments, i.e. trading futures, is much different than that of securities. The main difference here is that futures gains or losses are taxed as of the end of the year, whether you actually got out of the investment or not in that year.Â Any gains are treated as 60% long term capital gains (at up to a 15% maximum rate) and 40% short term capital gains (at up to a 35% maximum rate), regardless of the holding period. For example, an investor who holds a futures position for just a few minutes or hours can book 60% of the profits on that trade as long term gains - even though the trade was hardly long term. What a deal!
The enormity of this benefit for active traders should not be overlooked. Consider an investor weighing the differences between trading the QQQs and the e-mini Nasdaq futures. Equal profits in each instrument would be anything but equal after taxes, with the maximum combined rate for the e-mini NQs just 23% (calculation = 60% * 15% + 40% * 35%), versus a maximum rate of 35% for the QQQs. That’s a savings of 12% by using e-mini futures over the exchange traded funds. It’s no wonder e-mini volume has steadily grown year over year since being launched. For active traders, e-minis are simply the more cost effective choice.
The Back Story
But how did futures get such preferential treatment? It all started in the 1980s as the government tried to get a handle on the widespread use of “tax straddles” by professional commodities traders. Before the 1986 tax reform, commodities were taxed in much the same manner as securities, with insanely high short term capital gains taxes (of over 50%).
To help offset the often gaudy gains they were making, professional traders would put on â€śfakeâ€ť trades towards the end of the year via a â€śChicago spreadâ€ť or â€śNew York straddleâ€ť (which were essentially the same thing with only a geographic preference in terminology). In a spread trade, one side of the trade can be losing substantially while the other winning substantially, resulting in a net effect of zero. But these traders would game the tax system by offsetting the losing leg of the spread on the last day of the year, thereby realizing a large loss to offset against any gains for the year. They would then offset the winning portion on the first day of the new year, resulting in a net effect of zero, but booking a large loss in the previous year.
The government’s answer to the “tax spread” was the introduction of Section 1256 contracts, which was a label for futures and commodities investments. Under the new rules, section 1256 contracts were to be marked to market as of the last day of the year, and thereby considered sold (or bought) with the end of year prices for tax purposes. The age of the tax spread was dead, as now both profits AND losses were reported in the current year.
For honest commodities investors who may have had no intention of selling their positions at year end, having to mark their positions to market put them out a great deal; and the government compromised by allowing 60% of the marked to market profits to be deemed as long term gains. This preferential treatment has endured ever since, even after Congress tried to reduce it in the 2003 tax reform act.
To achieve similar restrictions against selling losers and keeping winners at the end of the year, securities laws have the Wash Sale rule, which disallows losses if the losing position is reentered within 30 days. Section 1256 contracts are exempt from the wash sale rule, giving commodities another benefit over securities. It should be noted that investors can achieve active trader status and become exempt from the wash sale rule on the securities side.
Even Losers Win?
If youâ€™re looking at losses from the previous year on your managed futures investments, this may bring you a small amount of comfort. You see, futures based investments do not have the same tax treatment most people are used to with their traditional investments in stocks and bonds. One of the benefits of this difference in tax treatment is the ability to bring losses three years back.
What does that mean, exactly? Well, assume that you made the following amounts in an actively traded managed futures investment: $10,000 in 2007, $15,000 in 2008, and $25,000 in 2009 when volatility was rocking. Assuming you are at the highest tax bracket (35%), you would have paid the government approximately $11,500 in taxes across those three years at the blended 23% capital gains tax rate for futures.
Now, assume the lower volatility in 2010 wound up dragging down your managed futures investments and left you with losses of $20,000. Futures contracts special tax treatment essentially allow you to take that -$20,000 loss back into 2008 and 2007 to offset part of those gains. After offsetting the $10K in 2007 and $10KÂ of the 2008 gains, you would have been left with just $30K in gains over the three years versus $50K, and your tax due across all three years would switch to just $6,900 â€“ a refund of about $4,600 (or about 40% of the taxes paid). This simplistic example is to illustrate the concept of bringing back losses â€“ the actual amount able to be brought back would vary based on several other factors.
Before you get too excited, realize that there are a few exceptions to this. For one, this is only available to individuals- not corporations, partnerships, or trusts. As such, and really, as always, it is best to consult your tax accountant for more information. Â But you can see this is quite a bit better than the puny $3,000 a year loss carry forward available in stock trading. (Again - those with active trader status can treat losses as ordinary gains/losses).
Finally, for those investors utilizing a trading system and/or professional Commodity Trading Advisor (CTA) there is yet another benefit. As with securities, investors may be able to claim a deduction for the system fees, CTA management fees, and CTA incentive fees paid throughout the year. This number is not included in the Section 1256 gains/losses calculations, so that number is actually higher than what you made on the investment net of all fees. Still, investors may be able to treat these fees as a deductible investment expense.
In conclusion, there is a lot to like about an investment in managed futures or a trading system from a tax perspective, especially when comparing it to an investment in actively traded stocks.
Filling out your tax forms:
Futures gains and losses should be reported on Form 6781 (http://www.irs.gov/pub/irs-pdf/f6781.pdf) for US citizens, which comes over onto Schedule D of Form 1040 on lines 4 and 11. Schedule D:Â http://www.irs.gov/pub/irs-pdf/f1040sd.pdf
*Some of the information in this article was verified with Attain Portfolio Advisor’s accountant John Lane, CPA and on the very comprehensive website:Â www.GreenTraderTax.com; a professional tax service; as well as an article by Robert A. Green, CPA, in the August 2003 issue of Active Trader magazine.
Forex trading, commodity trading, managed futures, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors.
The entries on this blog are intended to further subscribers understanding, education, and â€“ at times- enjoyment of the world of alternative investments through managed futures, trading systems, and managed forex.Â Unless distinctly noted otherwise, the data and graphs included herein are intended to be mere examples and exhibits of the topic discussed, are for educational and illustrative purposes only, and do not represent trading in actual accounts.
The mention of asset class performance is based on the noted source index (i.e. Newedge CTA Index, S&P 500 Index, etc.) , and investors should take care to understand that any index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices:Â such as survivorship and self reporting biases, and instant history.
Managed Futures Disclaimer:
Past Performance is Not Necessarily Indicative of Future Results. The regulations of the CFTC require that prospective clients of a managed futures program (CTA) receive a disclosure document when they are solicited to enter into an agreement whereby the CTA will direct or guide the clientâ€™s commodity interest trading and that certain risk factors be highlighted. The disclosure document contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA.