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| Spring Cleaning? Start By Sorting Your Stock Index Options |
05-18-2009 |
One of life’s enduring pleasures is the rejuvenating arrival of spring. Invigorated by the welcome return of mild temperatures, we exorcise winter in a ritual known as spring cleaning.
Away go the parkas, sweaters and snow boots, replaced by t-shirts, shorts and flip-flops. Stow the snow shovel, dust off the weed whacker. Even tax season seems far away once the lawn turns green and the daffodils bloom.
Spring cleaning also applies to your trading business, especially if you trade in stock index options. Now is a great time to sort out and segregate your stock index options for optimum tax treatment.
What’s all the fuss about stock index options? Simply put, the Internal Revenue Service has not clearly defined how it prefers to treat them in general, whether you trade in the so-called DJX, which are based on the Dow Jones, or other broad-based indices such as Standard & Poor’s or NASDAQ.
The Commodities Futures Modernization Act of 2000 (CFMA) gave traders a little help by expanding the definition of a “broad-based index” (10 or more securities) to include almost all futures and options on stock indices.
Based on that, stock index options should be treated as commodities worthy of the Section 1256 tax split, as opposed to narrow-based indices (nine or fewer securities), which are treated as securities and taxed at the ordinary capital gains rate.
But the IRS remains officially mum on that interpretation, leaving option traders and their tax advisors with more questions than answers.
Practically speaking, if you trade in stock index options, you can receive a significant tax advantage over securities traders under Section 1256.
Reporting index capital gains on IRS Form 6781 (Gains and Losses from Section 1256 Contracts and Straddles) allows you to split your capital gains on Schedule D, with 60% taxed at the lower long-term capital gains rate (currently 15%) and 40% at the ordinary or short-term capital gains rate of up to 35%. That combined rate of 23% amounts to a 12% advantage over the ordinary (or short-term) rate.
Because of this attractive 60/40 split, most commodities traders forego the “loss insurance” of mark-to-market accounting in order to reap the benefits of the lower capital gains rate.
The major hurdle to receiving the favorable 60/40 tax break isn’t the tax man, it’s your brokerage firm. That’s because your broker does not typically break out stock index options from normal options when reporting your transactions. Not surprisingly, few accountants want to separate the indices from your other trading activity.
The answer? Easy – simply open a separate account and use it solely for your stock index option trading. That way, the IRS clearly sees this activity as index options, even though your broker does not break them out that way.
It’s perfectly acceptable to mix different types of stock index options within this account (NASDAQ, Dow Jones, S&P, etc.) as long as everything in the account is an index trade.
What if you’ve already mixed your indices with your single-stock Microsoft, AOL and Yahoo options? If you try to treat them as 1256, it could flag the IRS.
The tax-smart way to handle this situation would be to treat all of the mixed index options as normal stock transactions on Schedule D (or as ordinary capital gains/losses on Form 4797 Part II if you elected mark-to-market accounting) and begin now to segregate your index options next year.
However you choose to report your stock index options, it is important to be consistent from year to year.
Need help with your spring stock cleaning? Now is a great time to contact Traders Accounting, your trader tax professionals. We can help you sort out your index trading, streamline your record keeping and optimize your tax savings in this IRS gray area.
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