Financial Reform Legislation Amends Section 1256 of the Internal Revenue Code to Provide Greater Certainty with Respect to the Tax Treatment of Swaps, Caps, Floors, and Similar Agreements


Among other things, the financial reform legislation signed by the President today mandates the formation of exchanges for certain types of derivative instruments. In response to the proposed legislation, concerns were raised that this aspect of the legislation would materially alter the U.S. federal income tax treatment of investments in these types of derivative instruments, specifically causing them to be subject to the mark-to-market requirement and special gain characterization rules of section 1256.

Section 1256 provides for “mark-to-market” treatment for "section 1256 contracts.” In general, a taxpayer holding a section 1256 contract is treated for tax purposes as having sold that contract for fair market value at the end of the taxpayer's taxable year, recognizing any gain or loss in the contract. The gain or loss recognized is subject to a special rule: 40% of any gain or loss is treated as “short term” capital gain or loss (i.e., the type of gain or loss recognized on capital assets held by the taxpayer for less than one year), and 60% of any gain or loss is treated as “long term” capital gain or loss.

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