Section 1256 contracts are named after the section of the Internal Revenue Code that governs them. This section of the code aims to prevent tax-motivated straddles that would defer income or convert short-term capital gains into long-term capital gains. To prevent that, this section of the code requires that these contracts be traded in an exchange using the mark-to-market system. This means that if you hold Section 1256 contracts at the end of the year, these contracts are treated as if they were sold at their fair market value on the last business day of the year, even though you still own them.
The gains and losses that result from the open contracts are recorded as 60% long-term and 40% short-term. This is true regardless of how long you actually held the contracts. When you later dispose of the §1256 contract, the gain or loss is adjusted for the previously recognized gain or loss.
Section 1256 contracts are:
Regulated futures contracts, such as commodities futures
Foreign currency contracts that are publicly traded
Nonequity options
Dealer equity options
Dealer securities futures contracts
Use Form 6781, Part I, to report the gains and losses on open Section 1256 contracts.
A "straddle" is when you hold contracts that offset the risk of loss from each other. If you realize a loss when you sell part of a straddle position, your loss will be limited to the amount of any unrecognized gain in the offsetting position. Any loss that can’t currently be deducted is carried over to the next tax year. The straddle-loss rules and exceptions are quite complicated.
For more information on reporting straddle losses, see the Form 6781 instructions and IRS Publication 550, Investment Income and Expenses.