When Can Bitcoin Positions Be Taxed as Mixed Straddles Subject to the Special Mixed Straddle Rules? - McDermott Will & Emery

When Can Bitcoin Positions Be Taxed as Mixed Straddles Subject to the Special Mixed Straddle Rules?


Taxpayers who enter into offsetting positions in actively traded personal property where one or more—but not all—of the positions making up a straddle are taxed as section 1256 contracts (while another offsetting position is not a section 1256 contract) are subject to the mixed straddle rules. Potential adverse consequences can be magnified or made more complex by application of these special rules. This article can help taxpayers understand and take action to minimize or avoid these consequences when such positions involve virtual currencies.

In Depth

Taxpayers often enter into offsetting long and short positions to minimize risk, defer tax, and convert long-term and short-term capital gain and loss to maximize the possible benefits of tax-rate differentials. Particularly onerous tax consequences can result if taxpayers enter into offsetting positions where one—but not all—of the positions making up a straddle are taxed as section 1256 contracts while another offsetting position is not a section 1256 contract. Taxpayers who enter into certain virtual currency transactions can be subject to the adverse consequences of holding mixed straddles and need to understand ways they can minimize or avoid these consequences.

Taxpayers who do nothing—whether intentionally or inadvertently—are subject to the “killer rule,” which applies to convert a short-term loss from a non-section 1256 position to a 60/40 loss (see Temp. Treas. Reg. § 1.1092(b)-2T(b)(2) (1986).). Short-term gains offset by 60/40 losses are left unchanged. The killer rule “converts” only one way—in the government’s favor—and it is a “killer” to any taxpayer with a substantial volume of mixed straddles. This one-way conversion typically has a punitive tax effect. (The killer rule can be avoided by making the elections and identifications discussed below.)

Taxpayers who hold positions in Bitcoins and Bitcoin futures or options traded on the Chicago Mercantile Exchange (CME) can be subject to the mixed straddle rules if they hold straddles where not all of the positions are in CME futures or options. For background reading on the straddle rules and section 1256 treatment, see McDermott’s article, “When Virtual Currency Positions are Subject to the Straddle Rules” and “Special Tax Rules Apply to Bitcoin Futures and Options and Might Apply to Positions in Ether and Other Virtual Currencies in the Future.” This article discusses the tax rules for mixed straddles; that is, straddles that consist of both section 1256 contracts and non-section 1256 contracts.

Overview of Straddle Rules

A tax straddle exists when a taxpayer holds two or more positions in personal property when one or more of the positions substantially diminishes the risk of loss with respect to another position (I.R.C. § 1092(d)(1)). Virtual currency positions are subject to the tax straddle rules if the virtual currency is actively traded personal property and the positions are offsetting (I.R.C. § 1092(a)(1); Treas. Reg. §§ 1.1092(b)–1T and –2T). The straddle rules require deferral of losses on an offsetting position until the gain positions are closed out.

Convertible virtual currency is “property” for tax purposes, and the Internal Revenue Service (IRS) applies general tax principles to transactions in virtual currency (Notice 2014-21, Q&A-1). By way of example, because Bitcoins have an equivalent value in actual currency, can be substituted for actual currency, are traded on an established online market, and can be purchased for or exchanged into US dollars or other actual or virtual currencies, it is likely that Bitcoins are subject to the straddle rules.

Mixed Straddles

A tax straddle is a mixed straddle if one or more of the positions in the straddle is a section 1256 contract and the other positions are not section 1256 contracts (I.R.C. § 1256(d)(4)(A)). If a taxpayer holds CME Bitcoin futures or options as well as other Bitcoin positions, the taxpayer probably holds a tax straddle that may be subject to the mixed straddle rules. Because section 1256 contracts are subject to 60/40 tax treatment while non-section 1256 positions are subject to short-term capital gain or loss, taxpayers could have an incentive to use mixed straddles to convert short-term capital gain into 60/40 gain. Congress enacted the mixed straddle rules to prevent such a tax conversion.

Why Special Rules Were Needed

In the absence of the mixed straddle rules, taxpayers could generate short-term loss in a non-section 1256 contract position and an offsetting 60/40 gain in a section 1256 contract. The short-term loss could then be used to mop up unrelated short-term gain (leaving the taxpayer with only long-term capital gain). The mixed straddle rules prevent taxpayers from doing this. They also prevent taxpayers from reporting 60/40 gain or loss on section 1256 contracts and (depending on the taxpayer’s holding period) 100% short-term or long-term capital gain or loss on their non-section 1256 positions (see Staff of the Joint Comm. on Taxation, 98th Cong., 2d Sess., General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 304 and 316-17 (Joint Comm. Print 1984)).

Choices Available When Holding A Mixed Straddle

Taxpayers with mixed straddles essentially have four choices if they want to avoid the killer rule:

  1. Elect Out of I.R.C. § 1256. A taxpayer can make a one-time section 1256(d) identified mixed straddle election that removes the section 1256 contracts in the straddle from section 1256 treatment. The mixed straddle remains subject to the straddle rules. Interest and carrying charges incurred to carry a mixed straddle position must also be capitalized.
  2. Make an “Identified Straddle Identification.” If a taxpayer’s mixed straddle qualifies as an identified straddle under I.R.C. § 1092(a)(2), the taxpayer can designate the straddle as an “identified straddle.” Instead of deferring straddle losses, the taxpayer must adjust the tax basis on the gain position to reflect the nondeductible straddle losses (T.D. 9678, 2014-32 I.R.B.). Interest and carrying charges incurred to carry the mixed straddle must also be capitalized.
  3. Straddle-by-Straddle Identification. A taxpayer can identify a mixed straddle using “straddle-by-straddle” identification under I.R.C. § 1092(b)(2). With straddle-by-straddle identification, the taxpayer nets all gains and losses on the mixed straddle. In addition, the taxpayer must defer recognition of pre-straddle gain or loss on any of the positions that had been open before the straddle was established (T.D. 9627 (Doc 2013-18683)) under Treas. Reg. § 1.1092-6T (Announcement 2013-45; 2013-47 I.R.B. 546.). The straddle rules still apply after the taxpayer makes the required computations (Temp. Treas. Reg. §1.1092(b)-3T(c) (1985)).
  4. Establish a Mixed Straddle Account. A taxpayer with a large number of mixed straddles can establish a mixed straddle account for each class of activities, with gains and losses recognized and offset on a periodic basis. In setting up a mixed straddle account, the taxpayer must carefully determine which positions qualify as a particular “class of activities.” It is not likely, for example, that a straddle account including Bitcoins could properly include other virtual currencies. The convenience of a mixed straddle account is offset by a tax cost. Not more than 50% of any net gain derived from positions in the account (whether or not otherwise qualified for section 1256 treatment) can be treated as long-term capital gain, while not more than 40% of any net loss can be treated as short-term capital loss (Temp. Treas. Reg. § 1.1092(b)-4T(c)(4) (1985)).

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Taxpayers should avoid the killer rule by selecting one of the mixed straddle choices set out in this article; doing nothing is never a recommended way to proceed. Loss on a non-section 1256 contract can be converted under the killer rule to 60/40 loss without also converting section 1256 contract losses to short-term capital losses. A taxpayer with a mixed straddle that produces a loss on the section 1256 contract position, a short-term gain on the non-section 1256 contract position, and a long-term capital gain from sources unrelated to the straddle will convert long-term capital gain to short-term gain (see House Conference Report, Deficit Reduction Act of 1984, H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 912 (1984)). The Treasury cannot impose the killer rule on positions other than those making up a mixed straddle (Arrow Fastener Co. v. Commissioner, 76 T.C. 423, 431 (1981); Koshland v. Helvering, 298 U.S. 441, 447 (1936), rev’g 81 F.2d  641 (9th Cir. 1936)).

Taxpayers should, on a regular basis (at least annually), carefully determine whether there is an established market for the virtual currencies they hold, therefore potentially subjecting their positions to the straddle rules. Next, they should determine whether they hold offsetting positions in those virtual currencies. And, if they hold both section 1256 contracts and non-section 1256 contracts, they need to evaluate whether those straddles are mixed straddles subject to the special rules that apply only to mixed straddles.

Taxpayers who believe they might hold mixed straddles should consult with their tax advisors to assure that they properly report federal and state tax. Many states do not follow the federal tax Code in computing state taxes.