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The Tax Benefits of a Managed Futures Investment
March 30, 2009
With less than one month until tax time in the US, many investors are compiling their investment records from 2008 and putting the final touches on their tax returns. For many investors, this means compiling a lengthy list of securities' cost basis, sales prices, purchase dates, and Schedule D's, but for those that invest in futures - the tax treatment is quite different.
Unlike stocks, futures based investments are based on their value at the end of the year, so any open trade profits or losses in the account are treated as realized profits or losses as of the last day of the year. In addition, futures based investments do not require the accounting of individual trades. Taxes on the security side are trade by trade based, and depend when you got into a certain investment and when you got out. Conversely, taxes on your futures based investments are only concerned with the gross profit or loss achieved using commodity futures contracts for the year. This is good news for investors who could be with an active CTA program or trading system which trades several hundred or thousands of times in a year.
Tax Advantages of Futures
No Trade by Trade Accounting
Profits/Losses treated as 60% long term cap gains, 40% short term cap gains
Losses carried back 3 years
No Wash Sale rules
*Tax law is complex, and regulated futures and option contracts even more complex. You should always consult your tax advisor with specific questions.__*Tax law is complex, and regulated futures and option contracts even more complex. You should always consult your tax advisor witspecific questions.
While both stocks (securities) and futures are eventually recorded as investment income or losses, there are big differences between the two for the purposes of your tax return. These differences are often overlooked by the average investor, but can add up to real tax savings. Let us first look at the securities side of things, which includes stocks, mutual funds, and ETFs (such as the SPDRs and QQQs).
As most Americans know, gains on securities such as stocks are taxed at either the short term capital gains rate of up to 35% or the long term capital gains rate of 15% (these rates are both possibly going higher with the new Obama administration). To receive the long term capital gains treatment, the securities investment must be held for longer than one year. One important thing to remember is that you are not taxed on the gain from a security until you sell that security. Thus if you bought GE 10 years ago and have held it ever since, you haven't paid any taxes on the gains of that investment, and won't until you sell (GE is actually down over 70% since 1999). Conversely, if you are an active trader and bought and sold the QQQs a few times in 2008, you are responsible for taxes equaling 35% of the gains.
The taxation of commodities investments, i.e. trading futures, is much different than that of securities. The main difference being that futures gains or losses are taxed as of the end of the year, whether you actually got out of the investment or not in that year. Any gains are treated as 60% long term capital gains (at up to a 15% maximum rate) and 40% short term capital gains (at up to a 35% maximum rate), NO MATTER the holding period. For example, an investor who holds a futures position for just a few minutes, or hours, can book 60% of the profits on that trade as long term gains - even though the trade was anything but long term. What a deal!
The enormity of this benefit for active traders should not be overlooked. Consider an investor weighing the differences between trading the QQQs and the e-mini Nasdaq futures. Equal profits in each instrument would be anything but equal after taxes, with the maximum combined rate for the e-mini NQs just 23% (calculation = 60% * 15% + 40% * 35%), versus a maximum rate of 35% for the QQQs. That's a savings of 12% by using e-mini futures over the exchange traded funds. It's no wonder e-mini volume has steadily grown year over year since being launched. For active traders, e-minis are simply the more cost effective choice.
But how did futures get such preferential treatment? It all started in the 1980s as the government tried to get a handle on the widespread use of "tax straddles" by professional commodities traders. Before the 1986 tax reform, commodities were taxed in much the same manner as securities, with insanely high short term capital gains taxes (of over 50%).
To help offset the often gaudy gains they were making, professional traders would put on “fake” trades towards the end of the year via a spread or straddle (Chicagoans call them spreads, New Yorkers straddles). In a spread trade, one side of the trade can be losing substantially while the other winning substantially, resulting in a net effect of zero. But these traders would game the tax system by offsetting the losing leg of the spread on the last day of the year, thereby realizing a large loss to offset against any gains for the year. They would then offset the winning portion on the first day of the new year, resulting in a net effect of zero, but booking a large loss in the previous year.
The government's answer to the "tax spread" was the introduction of Section 1256 contracts, which was a label for futures and commodities investments. Under the new rules, section 1256 contracts were to be marked to market as of the last day of the year, and thereby considered sold (or bought) with the end of year prices for tax purposes. The age of the tax spread was dead, as now both profits AND losses were reported in the current year.
For honest commodities investors who may have had no intention of selling their positions at year end, having to mark their positions to market put them out a great deal; and the government compromised by allowing 60% of the marked to market profits to be deemed as long term gains. This preferential treatment has endured ever since, even after Congress tried to reduce it in the 2003 tax reform act.
To achieve similar restrictions against selling losers and keeping winners at the end of the year, securities laws have the Wash Sale rule, which disallows losses if the losing position is reentered within 30 days. Section 1256 contracts are exempt from the wash sale rule, giving commodities another benefit over securities. It should be noted that investors can achieve active trader status and become exempt form the wash sale rule on the securities side.
The 60/40 treatment of futures makes futures the better choice when considering profits, but what about losses - which investment has the edge there? The answer once again is futures. Losses in securities can only offset gains by a puny $3,000 a year. (Again - those with active trader status can treat losses as ordinary gains/losses). Conversely, losses in futures(section 1256 contracts) can be carried back 3 years against section 1256 gains. Imagine an investor who had made $20,000 in 2004; $30,000 in 2005; and $40,000 in 2006 - only to lose a net $100,000 in 2007. This imaginary investor would have paid taxes at the 60/40 split in each of the previous three years - but could now carry the 2007 losses back three years - effectively wiping out the gains made in those years to earn a hefty refund on the taxes paid in '04, '05, and '06.
Finally, for those investors utilizing a trading system and/or professional Commodity Trading Advisor (CTA) there is yet another benefit. As with securities, investors may be able to claim a deduction for the system fees, CTA management fees, and CTA incentive fees paid throughout the year. This number is not included in the Section 1256 gains/losses calculations, so that number is actually higher than you what you made on the investment net of all fees. But investors may be able to treat these fees as a deductible investment expense.
In conclusion, the verdict on whether an active trader should utilize exchange traded funds like QQQs and SPDRs or index futures such as e-mini SPs and e-mini Nasdaqs appears to be no contest, as investments in futures appear to have more beneficial tax treatment at virtually every turn. It is no wonder e-minis have become so popular amongst both professional and novice investors.
Filling out your tax forms:
Futures gains and losses should be reported on Form 6781 (http://www.irs.gov/pub/irs-pdf/f6781.pdf) for US citizens, which comes over onto Schedule D of Form 1040 on lines 4 and 11. Schedule D: http://www.irs.gov/pub/irs-pdf/f1040sd.pdf
*Some of the information in this article was verified on the very comprehensive website: www.GreenTraderTax.com; a professional tax service; as well as an article by Robert A. Green, CPA, in the August 2003 issue of Active Trader magazine.
- Jeff Eizenberg
IMPORTANT RISK DISCLOSURE
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The unveiling of the Treasury’s next step in the economic bailout/bank rescue led to a strong rally in the stock index sector and sympathy moves in many commodities.
The new investor confidence and sentiment was evident in the stock index sector which saw another week of price rallies across the board, especially with the release of better than expected economic reports in the U.S. For the week Dow futures ended +7.58% higher, S&P 500 futures rallied +6.81% and NASDAQ futures +5.72%. In the Small Cap sector Mid-Cap 400 futures +8.33% and Russell 2000 futures +7.93%.
Meanwhile in the U.K., a terrible rate auction coupled with comments from various finance ministers that some E.U. countries were running alarming budget deficits made for volatile action in the currency and rate sectors. In the currency sector investors moved from most foreign currencies back into the U.S. Dollar as the proposed injection by the FED of up to $300 billion seemed to be a distant memory. The Dollar Index ended the week +1.47% with the Euro Currency -2.16%, Swiss Franc -1.54% and British Pound -0.95%. The Japanese Yen -2.11% found pressure on news of more trouble for institutions in Asia. In the rate sector investors’ appetite for stocks led to money re-allocation and the sector ending on weaker note as the 30-year Bond futures -0.70% and the 10-year Treasury notes ended -.87%.
In other news, inflationary ideas continued to be in the forefront of investors’ minds from the expected liquidity injection into the U.S. financial system, especially in the industrial area as building of infrastructure continues to be a main kingpin of an economic revival not only in the U.S. but abroad as well.
The inflationary vibes continued to help the industrial metals with Palladium +5.26%, Platinum +2.41% and Copper +2.23%. The precious metals lost some of their luster as investor confidence in other sectors seemed to chase away the safe haven structure with Silver -4.29% and Gold -3.56%.
The commodity and food arena ended the past week on a weak note with underlying supply/demand scenarios coming to the forefront after recent support on from inflationary ideas. Favorable weather conditions and position squaring ahead of the Quarterly USDA stocks and planting report seemed to be on traders’ minds in the grains. The Livestock trade was also soft as weaker product and cash markets ruled price activity in the futures. Soft commodities lost their appeal to investors due to worries that stockpiles could be larger than the market had anticipated as some countries have indicated a rise in supplies recently. Weekly changes in the Grains saw Wheat fall -7.57%, followed by Soybeans -3.68% and Corn -2.56%. Most of the soft sector declined with Sugar -6.89% leading the way followed by Cotton -1.78%, Cocoa -0.56% and Coffee -0.39%. Livestock sector saw Lean Hogs -2.28% and Live Cattle -1.19%.
Energies ended the week mixed as the products Heating Oil +2.91% and RBOB Gasoline +2.00% found support from lower refining capacity sparking speculation tighter supplies could be in the future. Crude Oil +0.52% found support from the product rally, but overhead pressure seemed strong after another weekly report of inventory stock increases. Natural Gas futures -13.31% moved to 6+ year lows due to heavy supplies which have prompted producers to cut costs and slow production.
With the last week of March upon us it is nail-biting time for most systematic multi-market managers. March has been a tough month for many managers as their programs have not responded favorably to the recent bear market rally which has also sent most commodities and foreign currencies higher, and bonds lower. After such a nice 2008 for many of these programs, a down quarter was probably in the cards anyway.
Moving forward we expect that the various programs and managers who have struggled thus far in 2009 will bounce back in the near future as more favorable market trends begin to emerge and we either breakout of the consolidation phase in place since December.
The Lone Wolf Investments LLC Diversified Program continues to be the leader in March with approximate returns of +2.91%. This discretionary trader has been leading the pack for the past two weeks and we expect that the Lone Wolf program will still be on top when final trades are punched tomorrow.
The remainder of the multi market managers tracked by Attain will most likely end March at breakeven or in the red. Those closer to breakeven include Clark Global Basic -0.09% est., DMH -0.48% est., and Dighton USA -0.63% est. The next group down on the returns list includes Clarke Global Magnum -1.46% est., Mesirow Financial Commodities Absolute Return -1.74% est., Hoffman Asset Management, Inc. -2.81% est., and Robinson-Langley Capital Management, LLC -4.91% est. Finally, our own APA Programs have not been immune to the recent volatility and are also down for the month. The full size APA Strategic Diversification Program is down approximately -4.00% for the month; while the APA Modified Program checks in at an estimated -7.00%.
Short term stock index managers have also struggled in March (as of Friday’s close). Short-term day trader MSLO has not found much success and is down -0.42%. Meanwhile, the countertrend Paskewitz Asset Management 3X Contrarian Program is down approximately -3.00% this month. A sharp one way move like we’ve seen over the past three weeks is exactly the scenario Paskewitz bets against.
Believe it or not, diversified commodity option selling CTA’s appear to be taking top honors for both the month and the quarter. Of the mangers we track there is only one manger, FCI, who falls into this category and happens to run two different programs – FCI (Financial Commodity Investments) original Option Selling Strategy (OSS) is ahead an estimated 4.75% for March and 16.78% in 2009 and the newer Credit Premium Program (CPP) is ahead an estimated 3.8% for March and 17.7% in 2009. These levels represent new equity highs for the CPP while the OSS remains in a drawdown just over 20% from its stumble last September/October.
The index option selling managers were not as fortunate, and struggled with the sharp move up in stock indices. Their estimates for March are as follows: ACE Investment Strategist -4.19%, Cervino Diversified Options -0.81% Cervino Diversified 2x -1.64%, Crescent bay PSI -5.46%, Crescent Bay BVP -14%, Raithel Investments -0.30%, and Zenith Index +0.31%.
Finally, agriculture and grain managers continue to remain cautiously optimistic about the markets ahead and as a result have remained mostly ‘on the sideline’ with just minor positions. For March the estimates are mixed with NDX Abednego ahead 0.29%, NDX Shadrach up 0.17%, and Rosetta giving back 1%. In a meeting with Rosetta late last week, manger Jim Green had the following comments; “There is a fundamental mispricing in the Corn and Lean Hogs market that we believe will move in our anticipated direction; however we are not going to get too aggressive until the trend is confirmed.”
Trading systems have been struggling across all time frames thus far in 2009 but there was some improvement last week. Most programs got off to a favorable start on Monday with a broad-based rally that triggered buy signals for most day-trading systems and a handful of swing systems but the rally lost some steam as the week continued.
Beginning with the day trading systems, Rayo Plus Dax was the top performer + 2,079€ for the week on four trades. Waugh eRL also finished the week on the rise with four trades totaling +$1,490. Compass SP and BetaCon 4/1 ESX managed to stay above water up +$87.5 and + 100€ respectively but would have been much better off had the week ended on Monday. Upper Hand ES had one trade on Wednesday that lost -$1,080.
Moving onto the swing trading systems, Strategic ES was up +$457.50 for the week on a trade that it held from Monday to Tuesday. AG Mechwarrior ES started the week strong but suffered a loss later in the week to bring the weekly total to -$135. Finally, Ultramini ES had one trade on Tuesday for a loss of -$367.50.
In long-term trading, the U.S. Dollar snapped back against the major foreign currencies just a week after most programs threw in the towel on their bullish Dollar Index positions. Most trend followers have trimmed their open positions significantly over the past few weeks after several key reversals starting with the rally in equity markets but will be scanning the markets for new potential entries in the weeks to come.
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.
Please read carefully the CFTC required disclaimer regarding hypothetical results below.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.