A 1256 Contract is a term used by the Internal Revenue Service to denote any regulated futures contracts, foreign currency contracts, non-equity options (broad-based stock index options (including cash-settled ones), debt options, commodity futures options, and currency options), dealer equity options, dealer security futures contracts[1][2], and cash settled options (including euro-style index options). They are marked to market at the end of the tax year[3] and treated as dispositioned (i.e., "closed").
IRS is not clear on whether QQQQ, DIA and SPY options should be treated as section 1256 contracts. On one hand, these do not settle in cash (most Section 1256 contracts do), but on the other hand they meet the definition of a "broad-based" index option.[4]
Any gain or loss from a 1256 Contract is treated for tax purposes as 40% short-term gain and 60% long-term gain. Typically the gain from any non-1256 contract will be taxed 100% at the short-term rate because the position is usually held for less than 12 months. Since most futures contracts are traded in a much shorter time frame than the 12 month rule required by the IRS for long term capital gains treatment, this creates an inherent tax disadvantage. Thus the 1256 Contract designation was created to enhance the after-tax attractiveness of these products.
Section 1256 contract net losses can be carried back 3 years (instead of being carried forward to the following year), but only to a year in which there is a net Section 1256 contracts gain, and only up to the extent of such gain (the carrying back cannot produce a net operating loss for the year). Tax reporting for Section 1256 contracts is significantly simpler than for stocks, options, and single-stock-futures.[5]