How Capital Gains Changes Could Affect Futures Traders

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How capital gains changes could affect futures traders

A change in the taxation of some or all capital gains will be a large part of Congressional deliberations over a new tax bill this year.

The good news is that traders and investors in futures contracts can view the retention of the "60/40" long-term/short-term mechanism as potentially favorable. The caveat is that recent proposals, rife with "carve-outs," could cause speculator concern over what impact a 1990 capital gains change will have on the taxation of futures contract positions.

The 1990s may mark the end of a trend for speculators who historically were rewarded, through capital gains tax treatment, for taking risk. For the first time in many years, such speculators will have to contend with a shift in capital gains thinking.

Among the issues these taxpayers will face are: * The repeal of the long-term capital gains exclusion from the Tax Reform Act of 1986. * President George Bush's 1989 tax-reduction proposal, which would reward longer-term investments. * "Carve-outs," or individual asset class determinations on tax breaks.

On the surface, it may seem the 28% maximum tax rate on current exchange-traded futures contracts compares favorably to the pre-1986 law maximum tax rate of 32%.

After assessing the combination of long-term capital gains exclusion and the former more progressive tax rate system, however, it becomes apparent that, for most speculative traders, repeal of the long-term capital gains exclusion under the 1986 act resulted in a much higher effective tax rate on trading gains. Basically, the increase in the effective tax rate would be true for all taxpayers except those in the 50% bracket.

Aside from repealing the long-term capital gains exclusion by the 1986 Act, Congress didn't change the basic statutory rules governing the taxation of regulated futures contracts. Internal Revenue Code Section 1256, originally enacted under the 1981 Tax Act, still provides for "mark to market" at year's end, ensuring that tax calculations on futures and options will include all unrealized profits and losses on open positions.

That result is then treated as a 60/40 long-term/short-term capital gain or loss "split" - gains and losses are 60% long-term and 40% short-term for all section 1256 contracts, including futures and options on futures, regardless of their holding periods. Maintaining this 60/40 split could lead to a lowering of the effective tax rate on individual traders' contracts, if there is a re-enactment of the capital gains preference.

Modern niches

"Carve-outs" of certain classes of capital assets (either qualifying or not qualifying for preferential treatment) are evidence of the new thought process on preferential tax treatment for long-term capital gains. Recent proposals have reflected a prevailing belief in Congress that "not all capital gains are equal."

Under the new proposals, the concept of the holding period has taken on greater importance. Historically, the six-month or one-year holding periods required for long-term treatment generally applied to all capital assets. …