Many Chinese friends in Austin who trade futures and index options run into an unfamiliar term at tax time: Section 1256 contracts. This is a special provision in U.S. tax law for certain derivative financial instruments, built around the 60/40 capital gains rate and mark-to-market taxation. For active traders, this can be the single most valuable treatment on the entire tax return. At the same time, many people trading funded accounts at prop firms (proprietary trading firms) mistakenly believe they also qualify for this treatment, only to discover during tax season that it's a completely different situation. This article explains both scenarios in full.
What Is a Section 1256 Contract?
Section 1256 is a provision in the Internal Revenue Service (IRS) tax code that covers the following categories of financial instruments:
- Regulated Futures Contracts, such as S&P 500 index futures (/ES), Nasdaq 100 index futures (/NQ), Micro Futures, and commodity futures;
- Broad-Based Index Options, such as S&P 500 index options (SPX), Nasdaq 100 index options (NDX), and Russell 2000 index options (RUT);
- Qualified Foreign Currency Contracts and Nonequity Options.
There is a common misconception worth flagging here: options on an ETF that tracks the same index do not count as Section 1256 contracts. In other words, SPX options qualify for 1256 treatment, but SPY options are treated as ordinary Equity Options — the same goes for QQQ options. Even though the two underlyings move almost identically, the tax treatment is completely different, and this is exactly where many traders pick the wrong instrument.
Core Mechanism One: The 60/40 Rule
If ordinary stock or single-stock options are held for less than a year, 100% of the gain is taxed as Short-Term Capital Gains, at the same rate as your ordinary income, up to 37%. With Section 1256 contracts, however, regardless of how long they are held — even if only for a few seconds — gains and losses are automatically split as follows:
- 60% is treated as Long-Term Capital Gains, eligible for the preferential 0%, 15%, or 20% rates;
- 40% is treated as short-term capital gains, taxed at ordinary income rates.
For taxpayers in the top bracket, this means a blended maximum rate of roughly 26.8% (excluding the 3.8% Net Investment Income Tax, NIIT, if applicable), rather than 37%. For the same day-trading profit, the after-tax difference between trading SPX options and SPY options can exceed ten percentage points. The more frequently and the larger the amounts you trade, the more significant this gap becomes.
Core Mechanism Two: Mark-to-Market
On the last trading day of each year, Section 1256 contracts are treated as if they were sold at their Fair Market Value, meaning unrealized gains and losses on open positions must also be included in that year's taxable income. This has two practical effects: first, even without closing a position, paper gains at year-end must be taxed in that year, so you need to plan cash flow in advance; second, the cost basis of the position is adjusted accordingly, so it won't be taxed again in the following year.
Mark-to-market treatment also brings a benefit that many overlook: the Wash Sale Rule does not apply to Section 1256 contracts. Traders who frequently enter and exit the same instrument don't need to track wash sale adjustments trade by trade the way they would with individual stocks — they can simply settle the net gain or loss at year-end, which significantly reduces the recordkeeping burden.
How to Report: Form 6781 and Schedule D
If you trade the instruments mentioned above through brokers such as Interactive Brokers, Schwab, or Futu moomoo, the 1099-B you receive at tax time will separately list the Aggregate Profit or Loss on Section 1256 contracts for the year. Report this figure on Form 6781 (Gains and Losses From Section 1256 Contracts and Straddles), which will automatically apply the 60/40 split, with the result carrying over to Schedule D. Your broker has already done the aggregation for you, so there's no need to report trade by trade — this is also why 1256 contracts are much simpler to report than individual stock trades.
Another special treatment worth knowing about is the Loss Carryback: if you have a net loss on Section 1256 contracts for the year, individual taxpayers may elect to carry the loss back up to three years to offset net Section 1256 gains from prior years and claim a refund. This is an option not available for ordinary capital losses (which can only offset $3,000 of ordinary income per year, with the remainder carried forward). Whether to make this election requires a comprehensive analysis based on your tax returns from the past three years, and it's advisable to make this decision with the help of a professional.
Special Note: Section 1256 Does Not Apply to Prop Firm Payouts
In recent years, prop firms such as Topstep and Apex have become very popular within the Chinese trading community: after passing an evaluation, you trade futures using the firm's funded account, and profits are split on a percentage basis. Many people naturally assume that "since I'm trading futures, my payout should naturally be taxed under 1256" — this is a costly misconception.
The key question is who bears the market risk. In a typical prop firm model, you are usually trading in a simulated account or an account held in the firm's name — ownership of the account and market risk both belong to the firm, and what you're contributing is not capital but trading skill. As a result, under tax law your relationship with the firm is more akin to that of an Independent Contractor, and the payout you receive is treated as compensation for services rather than capital gains. At tax time, prop firms generally don't issue a 1099-B; instead they issue a 1099-NEC (Nonemployee Compensation): this income is fully taxed at ordinary income rates and typically also subject to the 15.3% Self-Employment Tax, with no access to the 60/40 preferential treatment whatsoever.
Self-employment income isn't all bad news, though: reasonable trading-related operating expenses — such as data subscriptions, platform monthly fees, evaluation fees, equipment, and home office costs — can be deducted as business expenses when they qualify; and once your income reaches a meaningful scale, there's further planning potential through an appropriate entity structure (such as an LLC with corresponding tax elections). On the flip side, if you've already earned your first pot of gold through a prop firm, moving part of that payout into your own live brokerage account to trade futures or SPX options means that, from that point forward, your profits can legitimately go through the 1256 60/40 channel.
One more thing worth noting: the discussion above assumes you are a U.S. tax resident (Resident Alien). If you are a Nonresident Alien, the tax treatment of capital gains and self-employment income follows entirely different rules, involving tax treaties and withholding tax issues — please be sure to evaluate this separately. If you're not sure about your residency status, you can start by reading our Chinese Tax Filing Guide to clarify your filing status and process.
YZ CPA Note
YZ CPA would like to remind Chinese traders in and around Austin: first, tax cost should be factored into your choice of trading instrument — the after-tax difference between SPX and SPY options is real and significant; second, estimate the tax burden created by mark-to-market treatment on your year-end positions to avoid a cash flow crunch during tax season; third, prop firm payouts are self-employment income, so remember to make quarterly Estimated Tax Payments, or you may face underpayment penalties; fourth, in years when 1099-B and 1099-NEC income are mixed together, the interplay between Form 6781, Schedule D, and Schedule C is easy to get wrong, so it's advisable to leave this to a professional familiar with trader taxation. For more tax insights, visit our Tax Insights column.
If you'd like tax planning tailored to your trading structure, feel free to visit the YZ CPA Services page or contact us.