Trader Taxes: Form 8949 & Section 1256 Contracts

Due to the volume of transactions most traders have, their tax filings can often be more time consuming than the average investor's. That's because active traders may be subject to completing additional tax forms to report each individual trade. 

The main form used to report trades is Schedule D. Though this is the same form average long-term investors use to report capital gains, traders likely need to complete additional forms. 

Traders can think of the Schedule D as the summary page for all transactions, which are grouped together based on their holding period. A lot of traders will report their trades in the first section, which is for short-term transactions (assets held for a year or less). The net income from these trades is taxed at the higher ordinary income tax rates. The second part of the form is reserved for all long-term transactions (assets held for over a year), and the net gain is taxed at the lower long-term capital gains tax rate that ranges from 0% to 20%. 

For most traders, it won't be as simple as just completing Schedule D. To get all the info into Schedule D, they'll likely need to complete Form 8949. Traders subject to Section 1256 contract rules will also complete Form 6781. 

Here's a high-level look at basic filing requirements. 

Form 8949 is basically used to list each individual trade a trader has made. Most will likely be reported to the trader and the IRS on Form 1099, but this is not always the case. For example, the sale of cryptocurrencies is often not reported on a 1099, yet any crypto sell, swap, or transaction could result in taxable income, as can using cryptocurrency to purchase something, such as car or watch. Keep in mind that most property owned and used for personal purposes, pleasure, or investment is considered a capital asset, and any gain will be subject to taxes.

Like the Schedule D, Form 8949 separates transactions into short- or long-term buckets, but still reports every trade. There are other transactions—such as Section 1256 contracts (more on this below)—that don't fit into Form 8949 but will still appear on the Schedule D summary page.

All sales or exchanges, no matter how small, will need to be reported to the IRS. For a day trader with potentially hundreds or even thousands of trades, that task can be daunting. Fortunately, there are many tax software programs that can assist in this process, with some even being able to adjust for wash sales. For traders hesitant to do the paperwork themselves, a professional tax advisor will be able to do the heavy lifting. 

Traders of futures, foreign exchange, index options, or other mark-to-market products will need to file Form 6781, Gains and Losses Form Section 1256 Contracts and Straddles.

Section 1256 contracts get special tax treatment, which is commonly referred to as 60/40. This means no matter how long a trader held an asset, they'd receive 60% long-term capital gains tax treatment and 40% short-term capital gains tax treatment. For example, if a trader held a futures contract for three days and had a net gain of $1,000, $600 would be taxed at the long-term capital gains rate and $400 would be taxed as ordinary income.

The unique tax treatment of Section 1256 contracts does not stop there; generally, these contracts are not subject to wash sales rules. Additionally, if there is a loss on 1256 contracts, traders may be able to carry it back up to three years, potentially allowing them to offset gains in a prior tax year. 

Something that can catch some people off guard is that Section 1256 contracts are subject to mark-to-market accounting. That means any Section 1256 contract held at the end of the tax year is treated as if a trader sold it at its fair market value (FMV) on the last business day of that year, regardless of whether they actually sold the contract. That FMV then becomes the new cost basis when the trader eventually sells that asset. There are of course numerous other tax rules that can impact 1256 contracts. That's why we recommend meeting with a tax professional to help navigate the complexities these contracts can bring. 

Many people are surprised that not all investments are taxed at the short- or long-term capital gains tax rates. For instance, physical commodities, such as precious metals, are taxed as collectibles and may be subject to a higher long-term capital gains rate of 28%. This can even apply to exchange-traded funds (ETFs) that are commodity-based and hold physical gold, silver, or other metals. 

As a trader, making profitable trades should be the primary concern, but don't overlook taxes. Take the time to learn the basics of how taxes could impact you and seek guidance along the way from a tax professional to ensure you don't run afoul of the IRS. After all, it's better to get things right up front, rather than come away with a big tax bill with penalties and interest if you get audited.