2014 Top Stocks Market, Best Stocks Investment In 2014, Top Stocks For 2014: Nadex Binary Options Are Probably Taxed As Swap Contracts With Ordinary Gain Or Loss Treatment

By Robert A. Green, CPA, with help from our tax attorney Mark Feldman, and Darren Neuschwander, CPA

Traders are increasingly getting involved with Nadex and other “binary options” and they've been asking us how they are taxed. Are they taxed like securities (capital gains), futures (60/40 capital gains) or swap contracts (ordinary)?

Binary options are “bets” on the direction of an underlying financial instrument or the outcome of a financial event during a time frame chosen in the bet, which could be an hour or several months or more. Picture playing roulette with the spinning wheel and the ball landing on red (you win!) or black (you lose). It's an all or nothing bet based on how much you put down.

While binary options certainly have elements of gambling, we don't think the IRS can apply gambling-loss-limitation tax treatment. Gaming commissions regulate gambling on games of chance, whereas the SEC and CFTC regulate financial exchanges, including Nadex. We consider binary options on regulated exchanges like Nadex to be another faction of the ever-expanding trading marketplace. Clearly there are risks, especially when you fray from registered brokers and regulated exchanges.

Public companies and hedge funds often use swap contracts by making bets or swap payment agreements to manage risk. What's the difference? Most “derivatives” are privately negotiated agreements, often handled by investment bankers (yet Dodd-Frank now wants them to be cleared on futures exchanges). Nadex binary options originate on the exchange with price discovered and regulated clearing. For “risk on and risk off” trades, a manager can protect his portfolio without rushing to sell underlying securities, options or futures positions, which could cause a further drop in price. Binary options have a seat at the table.

Tax treatment is unclear
Unfortunately, the IRS has not issued specific guidance on tax treatment of binary options. Nadex does not provide tax information. Nadex says the CFTC designates its binary options as “swap contracts.” While a regulator's statements are informative, they are not dispositive for tax treatment.

Regulators weigh in
Read “SEC warns investors about binary options." It includes a good explanation of how binary options work. According to the article, “Binary options are securities in the form of options contracts whose payout depends on whether the underlying asset — for instance a company's stock — increases or decreases in value. In such an all-or nothing payout structure, investors betting on a stock price increase face two possible outcomes when the contract expires: They either receive a pre-determined amount of money if the value of the asset increased over the fixed period, or no money at all if it decreased.”

The SEC called binary options “securities” and “option contracts.” It's also possible they call swaps securities, too. The CFTC regulates Nadex and swaps and the CFTC labels Nadex binary options swap contracts.

Probable tax answer
We think the probable answer is binary options should be treated like swap transactions with ordinary gain or loss treatment.

Binary options resemble swap contracts; they don't involve ownership or trading of securities, futures, equity options or other types of “capital assets.” Each party makes a bet on a future development or event, with one party agreeing to make one or more fixed payments to the other party if the future event transpires. They are different from capital assets, where one party sells a capital asset with the other party investing in it. The investor owns an asset, which he can sell at any time for a capital gain or loss. The asset's price fluctuates based on market movements. Once a binary option contract is executed, the trigger for which party wins or loses is determined and the payment and “expiry” expiration date is fixed.

While many swaps contracts generally require multiple payments, binary options may only have one swap payment and that difference is not a material factor to us.

“If it were a swap payment, then it would seem to me that it should be treated the way a periodic or non-periodic swap payment is treated (ordinary income) rather than the way a termination payment is treated (capital gains under Section 1234A),” our tax attorney Mark Feldman says. “A termination payment (for all parties to a notional principal contract) is defined as ‘a payment made or received to extinguish or assign all or a proportionate part of the remaining rights and obligations of any party under a notional principal contract' and includes a payment made between the original parties to the contract (an extinguishment), a payment made between one party to the contract and a third party (an assignment), and any gain or loss realized on the exchange of one notional principal contract for another. This is not a payment to close out a position. Rather, the deal all along involved just one payment.”

A better label would be “binary swaps”
The Internal Revenue Code refers to “options” in many contexts. We believe the term “option” should have the same meaning throughout the Internal Revenue Code. Section 1234(a) refers to “an option to buy or sell property.” Binary options and swaps do not involve an option to buy or sell property.

Labeling the product “binary options” misleads users and confuses the tax treatment issue. Binary options are very different from equity options (securities) and non-equity options (Section 1256 contracts), which are both capital assets.

When you buy an equity option, you own the right — deemed a capital asset — to purchase a stock at a set price on a set date in the future. You can either sell that option before its expiration for a capital gain or loss or hold through expiration, either letting the option contract expire worthless or exercising your right to buy the stock. There is ownership of an asset, transferability, fluctuation in price and optionality.

Optionality means “The value of additional optional investment opportunities available only after having made an initial investment. The short-term payoff for this is modest, but the optionality value is enormous.” We don't think binary options have optionality per this definition; there is no further investment opportunity from the fixed payments conditional on future events or developments. There are no further strings or investments attached.

Here's another example of confusing labels: “Single-stock futures” are taxed as securities, not futures.

Can you use Section 1256 treatment?
If you have significant income from binary option transactions, you may seek to use Section 1256 to reduce your tax rate up to 12% using the lower 60/40 capital gains tax rates.

The general approach to getting into Section 1256 is to first look on the list of what's included: regulated futures contracts, broad-based indexes and options on those indexes, options on futures, certain foreign currency contracts and non-equity options. The ticket to entry to Section 1256 is often non-equity options. If an option is not an equity option, then perhaps it's a non-equity option. If we believed a binary option were a true option, we might be tempted into this line of reasoning. But we feel binary options aren't options.

The Dodd Frank tax reform law from 2010 called for swap contracts negotiated privately to be cleared on a qualified board of exchange. The Dodd Frank law clearly states that swap contracts may not use Section 1256 tax treatment. (Read our September 2012 blog “Tax Treatment for Swaps.”)

“The Nadex binary options are a challenge to tax advisors because they have certain characteristics of Section 1256 contracts (such as being listed on a qualified board or exchange) but the primary regulator, the CFTC, treats the contracts as swaps and not options and that is a very substantial hurdle to overcome for Section 1256 contract,” NYC tax attorney Roger D. Lorence says.

Tax compliance for binary options
The good news is taxpayers may deduct ordinary losses from gross income with exemption from capital loss limitations and wash sale loss deferral rules. It's generally a big tax benefit to deduct your losses when incurred.

It's like the default tax treatment for forex contracts in Section 988, which also have ordinary gain or loss treatment directly from gross income. As we point out in our extensive forex tax content, if a trader lacks trader tax status, he may wind up with some wasted losses if he has negative taxable income. In that case, he wouldn't have a business NOL or a capital loss carryover. Short-term capital gains are taxed like ordinary income.

There's more good news on accounting and reporting: Summary reporting is allowed. There's no need for line-by-line reporting as is required for securities transactions reported on Form 8949.

U.S. brokers probably won't include binary options on Form 1099-Bs since they are not “covered securities” or Section 1256 contracts — securities are reported on one 1099B and Section 1256 contracts are reported on a different 1099. Equity options are supposed to be covered securities starting with 2014 under the cost-basis-reporting transition rules, although it's more likely to be extended to 2015. Foreign brokers don't issue 1099s.

Swaps require mark-to-market tax treatment.

Trader tax status issues
Can trader tax status (business expense treatment) be used for expenses related to a high volume and frequency of binary options transactions, perhaps done on an intra-day basis? Probably. The expiry date could be in one hour and Nadex allows traders to enter and exit existing contracts. Regular trader tax status rules should apply.

Bottom line
The conservative approach is to treat binary options as swap contracts with ordinary gain or loss treatment. There's no capital asset involved, so why attempt to use capital gain or loss treatment? The IRS guards against people using Section 1256 when they should not as those tax breaks are highly coveted. So unless the IRS provides clear guidance allowing Section 1256 on binary options, why take that undue risk for back taxes, interest and penalties?

Nadex Binary Options Are Probably Taxed As Swap Contracts With Ordinary Gain Or Loss Treatment

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