Nonequity options that trade on a qualified exchange get a specific federal tax treatment under Internal Revenue Code Section 1256: a mandatory 60/40 split that taxes 60% of your gain or loss at long-term capital gains rates and 40% at short-term (ordinary) rates, regardless of how long you held the contract. Every open position is also marked to market at year-end, meaning you recognize gain or loss on December 31 even if you still hold the position. For a trader in the top 2026 bracket, that blend produces an effective federal rate of roughly 26.8% on option gains that would otherwise be taxed at 37% as short-term stock trades.
What Counts as a Nonequity Option
Section 1256 defines a nonequity option as any listed option that is not an equity option.1Office of the Law Revision Counsel. 26 USC 1256 – Section 1256 Contracts Marked to Market An equity option is an option to buy or sell stock, or one whose value is tied to individual stocks or a narrow-based security index. Everything else that trades on a recognized exchange lands in the nonequity bucket: options on broad-based stock indexes, interest rate options, foreign currency options, and commodity-linked options.
The contract has to trade on, or be subject to the rules of, a qualified board or exchange. That term covers a national securities exchange registered with the SEC, a domestic board of trade designated as a contract market by the CFTC, or any other exchange the Treasury has determined has adequate rules for Section 1256 purposes.2Legal Information Institute. Qualified Board or Exchange From 26 USC 1256(g)(7) An over-the-counter option, or one on an unregulated platform, does not qualify even if the underlying would otherwise fit.
Broad-Based vs. Narrow-Based Indexes
Most classification questions turn on whether the underlying index is broad-based or narrow-based. An option on a narrow-based index is treated as an equity option and loses Section 1256 treatment. Federal law defines a narrow-based security index as one that meets any of these conditions:3Legal Information Institute. Definition: Narrow-Based Security Index From 7 USC 1a(35)
- The index has nine or fewer component securities.
- Any single component makes up more than 30% of the weighting.
- The five largest components together account for more than 60% of the weighting.
- The lowest-weighted components making up 25% of the index have combined average daily trading volume below $50 million (or $30 million for indexes with 15 or more components).
An index that clears all four tests is broad-based. The S&P 500, Russell 2000, and Nasdaq-100 all qualify, so options on them get Section 1256 treatment. A sector index tracking only a handful of biotech stocks would fail the first test and be classified as narrow-based.
Which Contracts Qualify, and the ETF Trap
Commonly traded nonequity options include SPX (S&P 500 Index), NDX (Nasdaq-100 Index), RUT (Russell 2000 Index), VIX (Cboe Volatility Index), and DJX (Dow Jones Index). These are cash-settled options on broad-based indexes traded on Cboe or a similar qualified exchange, and they receive the 60/40 treatment.
Options on exchange-traded funds do not qualify, even when the ETF tracks a broad-based index. Options on SPY, QQQ, and IWM are equity options because the underlying instrument is a share of stock in the fund itself, and the statute defines equity options as options to buy or sell stock.1Office of the Law Revision Counsel. 26 USC 1256 – Section 1256 Contracts Marked to Market A trader who moves from SPY options to SPX options on the same underlying index picks up a meaningful tax advantage purely from that classification change.
How the 60/40 Rule and Mark-to-Market Work
Section 1256 does two things at once. First, every open position at year-end is treated as if you sold it at fair market value on the last business day of the year. You recognize gain or loss for that tax year even though you still hold the contract, and that mark becomes your basis going into January. Second, whether the position closed during the year or just got marked to market, 60% of the result is long-term and 40% is short-term.4Office of the Law Revision Counsel. 26 USC 1256 – Section 1256 Contracts Marked to Market Holding period is irrelevant. A position opened and closed in the same afternoon gets the same split as one held for months.
On a $10,000 gain for a trader in the top 2026 federal bracket, the math looks like this:
- The 60% long-term portion, $6,000, is taxed at up to 20%, producing up to $1,200 in tax.5Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
- The 40% short-term portion, $4,000, is taxed at up to 37%, producing up to $1,480 in tax.
- Total federal tax comes to $2,680, an effective rate of 26.8%.
The same $10,000 gain on a stock held less than a year would be taxed entirely at ordinary rates, up to $3,700. The mark-to-market rule means you cannot defer gains indefinitely by leaving positions open across tax years; your broker’s year-end settlement price sets the value.
No Wash Sale Rule
Losses recognized under the mark-to-market rule are exempt from the wash sale restrictions that apply to stocks and securities. Section 1256(f)(5) states that the wash sale rule does not apply to any loss taken into account under the mark-to-market provision.6Office of the Law Revision Counsel. 26 US Code 1256 – Section 1256 Contracts Marked to Market You can close a losing SPX position and immediately reopen an identical one without losing the ability to deduct the loss that year. With stocks and ETF options, buying a substantially identical position within 30 days would defer the loss; Section 1256 avoids that problem because every position is already settled for tax purposes at year-end.
Three-Year Loss Carryback
When your Section 1256 losses exceed your Section 1256 gains by more than $3,000 ($1,500 if married filing separately), you have a net Section 1256 contracts loss and can elect a carryback that ordinary capital losses do not get. Non-corporate taxpayers can carry that loss back to the three preceding tax years and offset Section 1256 gains reported in those years.7Office of the Law Revision Counsel. 26 USC 1212 – Capital Loss Carrybacks and Carryovers Corporations, estates, and trusts cannot use this election.8Internal Revenue Service. Form 6781 – Gains and Losses From Section 1256 Contracts and Straddles
To make the election, check box D on Form 6781 and enter the loss on line 6 as a positive number. Then file Form 1045 (Application for Tentative Refund) or an amended return for the carryback year, attaching an amended Form 6781 and Schedule D.8Internal Revenue Service. Form 6781 – Gains and Losses From Section 1256 Contracts and Straddles The loss carries back to the earliest eligible year first and keeps the 60/40 character. The carryback is capped at the Section 1256 gains reported in the carryback year and cannot create or increase a net operating loss.
Most capital losses can only go forward. The ability to carry Section 1256 losses backward and claim a refund on taxes already paid is one of the strongest practical benefits of the classification, and one traders routinely overlook.
The 3.8% Net Investment Income Tax
Section 1256 gains are investment income for purposes of the net investment income tax, which adds 3.8% if your modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly).9Internal Revenue Service. Topic No. 559, Net Investment Income Tax Those thresholds are not indexed for inflation.
Amounts reported on Form 6781 flow to Schedule D and then to Form 8960 on the line for net gain or loss from disposition of property.10Internal Revenue Service. Instructions for Form 8960 For a high-income trader subject to NIIT, the true maximum effective federal rate on nonequity option gains is 30.6% (26.8% plus 3.8%), not the 26.8% headline figure. Still lower than the 40.8% combined rate on short-term stock gains, but worth building into projections.
Reporting on Form 6781 and Schedule D
Your broker reports Section 1256 results on Form 1099-B. The relevant figure is Box 11, the aggregate profit or loss from all your Section 1256 contracts for the year. That number combines realized gains and losses from closed positions with unrealized gains and losses from open positions marked to market at year-end.11Internal Revenue Service. Instructions for Form 1099-B
Transfer the Box 11 amount to Part I of Form 6781, showing the broker’s name and the aggregate profit or loss. If you traded through more than one broker, list each on a separate line. The form does the 60/40 split for you: Line 8 gives the 40% short-term amount, Line 9 gives the 60% long-term amount.8Internal Revenue Service. Form 6781 – Gains and Losses From Section 1256 Contracts and Straddles The short-term amount then carries to Schedule D, Line 4, and the long-term amount to Schedule D, Line 11. Keep these separate from stock and ETF option trades, which belong on different lines of Schedule D. Most tax software handles the transfer automatically once you enter the 6781 data.
If you held offsetting positions that constitute a straddle, Part II of Form 6781 applies, and loss on one leg is deductible only to the extent it exceeds unrecognized gain on the offsetting position.8Internal Revenue Service. Form 6781 – Gains and Losses From Section 1256 Contracts and Straddles Straddle loss deferral is one of the more complex areas of derivatives taxation and is the kind of item that draws IRS attention when handled incorrectly.
Matching, Penalties, and Records
The IRS receives a copy of your 1099-B and runs automated matching against your return. If the amount on Form 6781 does not tie to Box 11 from your broker, expect an underreporter notice. The accuracy-related penalty for a substantial understatement of income tax is 20% of the underpaid amount, with “substantial” defined as the greater of 10% of the tax owed or $5,000.12Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
Keep brokerage statements, year-end confirmations, and your completed Form 6781 for at least three years from the date you filed the return, the general statute of limitations for most income tax returns.13Internal Revenue Service. How Long Should I Keep Records If you elected the three-year loss carryback, hold the records for those earlier years too, since the amended returns can extend the window the IRS has to review.