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The silver lining of Managed Futures 2009 losses - a tax refund in 2010
March 22, 2010
As we’ve covered a few times in this space over the past year, 2009 was less than ideal for managed futures, as evidenced by the Newedge CTA Index seeing its first annual loss since inception. A massive decrease in global volatility in nearly all markets left many managed futures programs in the red for the year, after those same programs had above average performance in 2007 and 2008 when volatility was expanding.
Why mention this now – nearly three full months into 2010? Because with less than one month until tax time in the United States, many investors are compiling their investment records from 2009 and putting the final touches on their tax returns. And after banner years for managed futures in 2007 and 2008, any losses you had via managed futures or trading systems in 2009 are going to start to look really good to you when putting together you tax return. How can losses look good? The can look good when they can potentially lead to you getting some money back. That’s right - the silver lining of the losses for managed futures in 2009 is the potential tax refunds individuals can get.
You see, futures based investments do not have the same tax treatment most people are used to with their traditional investments in stocks and bonds. And one of the most important differences this year is the ability to bring futures based investment losses back three years.
What does that mean, exactly? Well, assume that you made the following amounts in an actively traded managed futures investment: $10,000 in 2006, $15,000 in 2007, and $25,000 in 2008 when the volatility exploded. Assuming you are at the highest tax bracket (35%), you would have paid the government approximately $11,500 in taxes at the blended 23% capital gains tax rate for futures (more on that later). Now, assume the volatility implosion in 2009 left you with losses of -$20,000 in 2009. Futures contracts special tax treatment essentially allow you to take that -$20,000 loss back into 2006 and 2007 to offset part of those gains. After offsetting the $10K in 2006 and $10K of the 2007 gains, you would have been left with just $30K in gains over the three years versus $50K, and your tax due across all three years would switch to just $6,900 – a refund of about $4,600 (or about 40% of the taxes paid). [this simplistic example is to illustrate the concept of bringing back losses – the actual amount able to be brought back would vary based on several other factors].
There are a few caveats to this – one being that it is only available to individuals, not corporations, partnerships, or trusts; so, as always, it is best to consult your tax accountant for more information. Without being an accountant, we can still tell you the gist of it is that the 2009 losses weren’t all bad, because you can actually use them to recoup tax paid on past gains. But don’t go hoping for more losses in 2010 or anything like that; managed futures as a whole wouldn’t mind a nice bounce back to the upside in 2010, even if it means paying taxes instead of bring them back.
What else is different with futures tax accounting versus stocks?
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% (the recently passed health care bill actually tacks on 3.8% to these rates for those in the top tax bracket – CNN story) 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 60% since 2000). Conversely, if you are an active trader and bought and sold the QQQs a few times in 2009, 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 from 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? As covered in the beginning of the article, 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.
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 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, there is a lot to like about an investment in managed futures or a trading system from a tax perspective, especially when comparing it to an investment in actively traded stocks.
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 with Attain Portfolio Advisor's accountant John Lane, CPA and 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.
IMPORTANT RISK DISCLOSURE
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Overall market action in most sectors was fixed in a mixed to choppy state during the past week as worries about Greek sovereign debt and uncertainty over the weekend vote on a revamp of the healthcare system in the U.S. by the House had an unsettling effect on most areas of trading. The unsettling tone was evident in the stock index sector as large caps led by the Dow futures +1.08%, S&P500 futures +0.89% and NASDAQ futures +0.42% ended with slight price advances with the small cap Russell 2000 futures -0.59 and Mid-Cap 400 futures -0.13 posting slight declines.
Another round of stronger economic reports in the U.S. did aid pro growth support in the metal sector, although worries about the possibility of China curbing strong growth capped some of the industrials. Palladium +1.16% led the advancers followed by Gold +0.54% and Platinum +0.02%. Copper -0.22% and Silver -0.09 posted slight declines.
Worries of a possible slowdown in Chinese demand hampered price activity in the energy area along with continued supply burdens in the U.S. Natural Gas futures -5.33% led the sector lower followed by Heating Oil -0.77%, Crude Oil -0.70% and RBOB Gasoline futures -0.17%.
News that the EU membership was split about aiding Greek sovereign debt issue or pointing the country to the IMF for aid sparked pressure on the continentals and aided trading activity in the U.S. Dollar index +1.12% and Japanese Yen +0.04%. The Euro -1.75% led the European fall followed by the British Pound -1.22% and Swiss Franc -0.38%.
Commodity and Food products were mixed during the past week as fundamental factors seemed to rule price activity in most cases. Soybeans +3.91% and Corn +2.80% got a boost from better demand while wheat -0.33% was hampered by improved U.S. growing conditions. Livestock activity was firm with Live Cattle adding +3.10% as muddy pens in most U.S. cattle feeding regions have tightened market ready supplies with Lean Hogs +0.99% following along. Soft sector price action was mixed with OJ -4.15% and Cocoa -2.95% hampered by ideas of better crop prospects due to improving weather. Cotton +2.13% and Coffee +1.61% ended higher on demand improvement.
Multi – market managers bounced back slightly last week. There have been several nice trends in the commodity markets of late. Notably, there have been substantial trends in sugar, cotton, foreign currencies, the dollar index, as well as the stock market, which continues to climb higher. Accela Capital Management Global Diversified +2.60% est. continues to be the top performer in March. The next best manager thus far in March has been Robinson Langley Capital at +1.01%. Other profitable managers include Integrated Asset Management Global Concentrated +0.64%, Dominion Capital Management Sapphire +0.56%, Clarke Capital Worldwide +0.46%, Dighton Capital USA Aggressive Futures Trading +0.07%, Mesirow Absolute Return +0.04%, and Mesirow Low Volatility +0.01%.
Multi-market managers in the red include DMH -0.07%, APA Modified -0.07%, 2100 Xenon Managed Futures (2X) Program -0.28%, Hoffman Asset -0.48%, APA Strategic Diversification Program -0.58%, Quantum Leap Capital -1.81%, Clarke Capital Global Magnum -2.15%, Futures Truth MS4 -3.16%, Clarke Capital Global Basic -3.50%, GT Capital Dynamic -3.73%, and Futures Truth SAM 101 -6.22%.
Countertrend short-term ES traders have had a very tough month of March. Stocks have been grinding higher, day-after-day, and it has been difficult to hold onto short trades over the last couple of weeks. One notable manager that has struggled is Paskewitz Asset Management Contrarian 3X Stock Index at -11.55%. Paskewitz has been short for most of the recent rally until recently when they covered the majority of the trade. Sequential Capital Management fared better at +0.03%, but they typically trade with the market trend.
With just 8 trading days left in the month it has been a mixed bag of returns for many Option Trading managers as the range of performance between the top and bottom performers has been quite wide. On the plus side, Crescent Bay BVP is leading the way +2.85%. Other Option Trading estimates are as follows: ACE SIPC -1.12%, ACE DCP +1.13%, Cervino Diversified Options +0.17%, Cervino Diversified 2x +0.27%, Crescent Bay PSI -0.88%, FCI OSS -0.16%, FCI CPP +0.2%, and HB Capital +0.43%.
Historically, Specialty managers listed in this section have ranged from Agriculture and Grain specialist to Spread Trading specialist. New this month, we have begun tracking the 2100 Xenon Fixed Income program as a Fixed Income specialist. In an environment where interest rates are a discussion daily in various journals and publications, we believe that adding exposure to this space makes a great deal of sense. Where else can you find an investment that tracks and trades 19 US and International fixed income markets both long and short? The 2100 Xenon Fixed Income program has averaged an annualized return of +4.13% (+2.97% YTD through February) with a maximum drawdown of -7.13% since inception in August 2004 and for a limited time is being offered at a 500k minimum investment…aggressive investors may be interested in adding the program with 100k in cash traded notionally at the 500k trading level resulting in 5x the returns and drawdown.
Current Specialty manager estimates for the month are as follows: Emil Van Essen +0.17%, NDX Abednego -0.64%, NDX Shadrach -0.37%, Rosetta Capital +0.88%, and 2100 Xenon -0.95%.
Systems had a slow week of trading, as the markets remained calm for the majority of the week despite the FOMC meeting on Tuesday. Activity picked up a little bit on Friday as the markets sold off, however most systems chose not to trade. Of those that were active, the top performer was soybean swing trader MoneyBeans S +$1602.50 on 3 trades. Other profitable systems include BAM 90 +$585.0, Strategic SP +$475.00, AG Mechwarrior +$390.00, UpperHand ES +$277.50, and PSI! ERL +$220.00. Waugh CT ERL was at breakeven for the week.
Strategies that did not fare as well include Polaris ES -$42.50, Compass SP -$140.63, Clipper ERL -$440.00, MoneyMaker ES -$447.50, BAM 90 Single -$505.00, Strategic NQ -$570.00, Strategic ES -$622.50,
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.