How Are Taxes Filed for Futures Trading?

Introduction

The universe of futures presents highly leveraged opportunities. However, if you are a trader considering futures trading, you should have a fundamental understanding of the process in which futures are taxed. In this article, we will be covering exactly that.

How are Futures Taxed?

Compared to equity traders, futures traders benefit from a more favorable treatment of taxes. According to section 1256 of the IRC (Internal Revenue Code), any futures contract traded on a U.S exchange, foreign currency contract, dealer equities option, dealer securities futures contract, or non-equity options contract are taxed at 60% long-term capital gains rates and 40% short-term capital gains rates (60/40) - regardless of how long the trade was actually held.

Long-term capital gains rate(s) are 0%, 15%, or a maximum of 20% which is dependant on the overall taxable income and filing status for the corresponding year. Short-term captial gains rates however, are taxed at the "ordinary income" tax rate which is a maximum of 37%.

Since the highest capital gains rate for the long-term is 20% (most common = 15%), and the maximum ordinary income rate is 37%, the average maximum combined tax rate for trading futures would be 26.8%.

Taxable Futures Trading Example(s)

Let's say a futures trader is being taxed at an ordinary income rate of 30% and was able to earn $10,000 from their futures trading activities. In such case, it would be broken down as follows:

$10,000 futures trading profit x 60% long-term captial gains rate (15%): $6,000 x 15% = $900
$10,000 futures trading profit x 40% short-term captial gains rate (30%): $4,000 x 30% = $1,200
Total taxes paid on profit derived from trading futures = $2,100

Also, every contract under section 1256 will be ‘marked to market’ at the conclusion of every year. Traders are allowed to report all unrealized or realized gains or losses, and shall be exempt from all wash-sale regulations.

For instance, let us suppose that a trader bought a $30,000 contract in February 2021 and rolled over at each contract expiration. Now, on the final day of the tax year, that is, December 31st, 2021, the contract’s FMV (Fair Market Value) stands at $36,000. Trader will now be recognizing a $6,000 ($36,000-$30,000) capital gain on his 2021 tax return. This gain of $6,000 will be taxable in the 60-40 ratio.

Now, if trader sells the contract in 2022 for $34,000, he will have to enter a $2,000 ($36,000-$34,000) loss on his tax return for the year. This loss will also taxable in a 60-40 proportion.

If any future trader wishes to carry back the losses, Section 1256 allows this for a maximum period of three years, provided that the carried back losses are not more than the gains accumulated during the previous year and are not increasing the operating losses for the current year. The loss will initially have to be carried back to the earliest year, and any remaining loss amount can then be carried to the two subsequent years. Once again, the 60-40 rule will be applicable. If there are any losses that remain unabsorbed even after carrying back, they can be carried forward.