On July 21, 2010, the President signed into law H.R. 4173, the “Restoring American Financial Stability Act of 2010” (the Act). This landmark financial reform package contains one Code amendment broadening the list of contracts that are excepted from the definition of Code Sec. 1256 contracts and thus are excepted from mark-to-market treatment.

New exclusions from Code Sec. 1256 treatment. Taxpayers must report gains and losses from regulated futures contracts and other “Section 1256 contracts” on an annual basis under the “mark-to-market” rule. All Section 1256 contracts must be marked to market at year end. Each Section 1256 contract held by a taxpayer is treated as if it were sold for fair market value on the last business day of the year. If a taxpayer holds Section 1256 contracts at the beginning of a tax year, any gain or loss later realized on the contracts must be adjusted to reflect any gain or loss taken into account with respect to the contracts in an earlier year.

Any capital gain or loss on a Section 1256 futures contract that is marked-to-market is treated as if 40% of the gain or loss is short-term capital gain or loss, and as if 60% of the gain or loss is long-term capital gain or loss.

The term Section 1256 contract means: regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer securities futures contracts. Under pre-Act law, the term Section 1256 contract does not include any securities futures contract or option on such a contract unless the contract or option is a dealer securities futures contract.

New law. For tax years beginning after July 21, 2010, the Act provides that all of the following also are excepted from the definition of a Section 1256 contract: any interest rate swap; currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement. ( Code Sec. 1256(b) , as amended by Act Sec. 1601)

The Conference Report explains that the change addresses the recharacterization of income as a result of increased exchange-trading of derivatives contracts by clarifying that Code Sec. 1256 does not apply to certain derivatives contracts transacted on exchanges.