Section 1256 vs 988: how your trading gets taxed
Distinguish between Section 1256 and Section 988 tax treatment of trading gains so a US trader knows which return their broker statement falls under.
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Market Foundations + Forex Mechanics
US-Specific Trader Path
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Distinguish between Section 1256 and Section 988 tax treatment of trading gains so a US trader knows which return their broker statement falls under.
Two tax buckets, very different outcomes
Two trading accounts. Same year. Same profit. Different tax bill. Welcome to the US tax code. The instrument you trade decides which 'section' of the Internal Revenue Code applies — and the two main ones for traders are wildly different. Before we go further: this lesson is education, not tax advice. Talk to a CPA before you file anything.
Section 1256 covers regulated futures, broad-based index options like SPX, and foreign currency futures. It uses a special split: 60% of your gains are taxed at long-term capital gains rates, 40% at short-term, regardless of how long you actually held the trade. For a high-bracket trader, that's a meaningful break — you get long-term-style treatment without the 12-month holding period. The catch: gains and losses are marked to market at year-end, so unrealized P&L on December 31 gets taxed even if you don't close the position.
Section 988 is the default for spot forex — the EUR/USD, GBP/USD, USD/JPY trades most retail traders place at NFA-registered dealers. Under 988, your forex gains are treated as ordinary income, same as wages. That can be a worse rate if you're in a high bracket, but it has one advantage: 988 losses can offset ordinary income without the $3,000 annual cap that applies to ordinary capital losses. So a losing year on spot forex is a little more flexible on the deduction side.
Can you opt out of 988? Yes — there's an election to treat spot forex gains under capital gains rules instead. It's called the 'opt-out' or 'Section 988(a)(1)(B)' election. Two big rules: the election must be made BEFORE you place your first trade of the year, and it must be filed as a contemporaneous internal record (not added to your return after the fact). Get the timing wrong and the IRS will treat your gains as ordinary income anyway. This is exactly the kind of thing a CPA who specializes in trader tax handles for you — it's not a DIY move.
Recap: 1256 = futures and broad-based index options, 60/40 split. 988 = spot forex, ordinary income (with opt-out election available). Talk to a CPA. Not tax advice.
Knowledge check
Answer before moving on.
1. You trade ES (S&P 500 futures). What's the default tax treatment for your gains?
2. You trade spot EUR/USD all year at a US retail forex broker. You did not file any tax election. How are your gains treated?
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