Getting in on single-stock futures? Watch for these potential tax surprises
Single-stock futures permit investors to bet on some of their favorite names nearly all day, but a slate of tax complexities await these active traders. In late July, CME Group launched cash-settled single stock futures on more than 50 stocks, including Apple , Nvidia , Micron Technology and SpaceX . These products, along with 22 micro-sized contracts, trade 23 hours a day — from Sunday night through Friday afternoon. With these instruments, you don’t own the actual underlying stock, but you can use the contracts to take leveraged long or short positions in those names. Traders will want to slow down and work with their financial planner and tax advisor before jumping into these contracts. The products are so novel that the tax implications of using them aren’t immediately clear. “With new products, it can fill a particular niche, but regulation isn’t as fast as innovation,” said Cary Sinnett, certified financial planner and director of personal financial planning at theAmerican Institute of Certified Public Accountants. “The particular tax treatment might not be as favorable as you’re guessing.” Tax treatment confusion Retail traders who dabble in options are likely familiar with the 60/40 tax treatment that applies to options contracts on commodities, futures and broad-based market indexes. These are known as ” Section 1256 ” contracts. With Section 1256 contracts , regardless of how long you may have held the position, 60% of the gain is taxed at the favorable long-term capital gains rate – which can be 0%, 15% or 20%, depending on your taxable income – and 40% is subject to the short-term rate, which is the same as ordinary income, and can be as high as 37%. The surprise for retail traders using single-stock futures is that this beneficial tax treatment will not apply. That means if you’re actively trading these contracts and selling them after owning them for less than a year, you’re going to be taxed at the same rate as ordinary income. “I think the biggest tax trap will be that people hear ‘futures’ and assume that they’re taxed like 1256 contracts, where you get that 60/40 split – and that doesn’t seem to be the case,” said Albert Campo, CPA and president of Campo Financial Group in Freehold, N.J. “People will go off of their assumptions and then realize what actually happens come tax time,” he added. Hedging complexities For retail traders who plan to use single stock futures to hedge positions in their portfolios, there’s also the risk of incurring what’s known as a ” constructive sale .” Consider a taxpayer with a $2 million position in a stock with a low cost basis – meaning that the original price was low and the holding has seen considerable appreciation. The investor could theoretically try to use a single stock contract to eliminate downside risk. “If the hedge substantially eliminates downside and upside exposure, the IRS may deem the position to have been constructively sold,” said Sinnett. In this case, the taxpayer would be on the hook for capital gains taxes on the appreciation – which can be substantial if the cost basis is low. “It’s not a small concern if you’re doing it in a very large position,” Sinnett added. “Someone who owns the underlying stock, especially at a low cost basis, would be more at risk using the single stock future.” Wash sale question Active retail traders who regularly prune and add to their positions may be familiar with the wash sale rule: If you sell a losing position, you cannot claim the loss on your taxes if you buy a “substantially identical” security within 30 days before or after the sale. You can also violate the wash sale rule if you sell the asset in a taxable brokerage account and then buy it back in a retirement account. The question is whether you can still claim a loss if you sell the actual stock and buy the single-stock future shortly after the sale – and the answer is unclear. “Part of the wash sale rule is whether or not its substantially identical, and if you don’t receive the stock, does that activate ‘substantially identical’?” said Sinnett. “That’s a fair question that needs to be resolved.” This could be an area that piques IRS interest as usage of single-stock futures grows, he said. These questions shouldn’t necessarily keep traders from using these instruments, but they should encourage investors to consider their circumstances and all of the holdings in their portfolios before buying single-stock futures. “Talk to your tax advisor and see what that may look like for your specific tax situation before you get into these things,” said Campo.
