Straddles are defined in IRC section 1092(c) as two or more offsetting positions in personal property. A taxpayer holds offsetting positions with respect to personal property if the taxpayer’s risk of loss from holding any position is substantially reduced by reason of their holding one or more other positions with respect to personal property—whether or not of the same kind.

Although taxpayers may mitigate their effect, very few—if any—good tax consequences flow from having a straddle. Negative consequences include the following:

• Under IRC section 1092(a)(1)(A), deferral of losses will be recognized on the closing of one leg of a straddle to the extent that there are unrecognized gains on the other legs of the straddle.
• Under IRC section 263(g)(1), interest expense or other carrying costs must be capitalized to the extent they are incurred to purchase or carry any property that is part of a straddle.
• Under Treasury Regulations section 1.1092(b)-2T, the position creating the straddle will not accrue any holding period while the straddle remains in existence.
• Under Treasury Regulations section 1.1092(b)-2T, the holding period of the position being hedged will be destroyed and will not begin to accrue again until the straddle is terminated if it has been held for less than one year at the time the straddle is created.
• Under Treasury Regulations section 1.1092(b)-2T, if the position being hedged has been held for more than one year at the time the straddle is established, then any losses on the position creating the straddle will be treated as long-term and any gains will be short-term.

When dealing with straddles, it is important to determine the size and number of straddles. Assume that A owns 10,100 shares of ABC stock and purchases 100 “at the money” puts covering 10,000 shares of ABC stock. It would be difficult to argue that the puts don’t substantially diminish the risk of loss on all of the shares. If, however, A holds 1,000,000 shares of ABC stock and purchases 100 “at the money” puts, it is obvious that the puts do not substantially diminish the loss on all 1,000,000 shares.

Also assume that A owns 10,000 shares of ABC stock and purchases 100 “at the money” puts. How many straddles does that create? Is it one big straddle, or is it 100 straddles with each straddle consisting of one put and 100 shares? If it is one big straddle, the investor will have to recognize most of the gains in order to recognize any of the losses. If it is treated as 100 straddles, however, as each put and 100 shares are disposed of, the loss on those pieces may be recognized.

Finally, assume that A owns 100,000 shares of ABC and buys puts, hedging only 50,000 shares. A borrows against the entire position an amount that could have been supported by putting up 50,000 shares as collateral. How much interest expense must be capitalized?

The use of the identified straddle may be used to obviate some of these issues.

Under IRC section 1092(a)(2)(B), to establish an identified straddle, the straddle—which must not be part of a larger straddle—must be identified on the taxpayer’s books and records by the close of the day on which it is established. As long as the taxpayers make a timely identification and apply a consistent methodology, the IRS has accepted the identifications as valid.

There are two major differences between an identified straddle and straddles that are not identified. First, the loss deferral rules do not apply to the losses recognized on closing part of the identified straddle. Instead, the losses are capitalized into the remaining piece of the straddle with the unrealized gain. Second, the identification has the effect of controlling the size of the straddle as long as the methodology used to identify the straddle is reasonable and consistently applied.

Therefore, in the examples in which the taxpayer owned more shares of ABC than the shares represented by the purchased puts, the taxpayer can limit the number of shares being straddled by the puts with a timely identification. The effect of capitalizing the loss into the remaining legs of the straddle has the effect of treating the straddle of 10,000 shares and 100 puts as 100 straddles—that is, if all of the puts are sold for a loss or allowed to expire worthless, the loss on the puts will be capitalized into each of the 10,000 shares, assuming that each of the shares has the same basis. In this case, if 2,000 shares are subsequently sold, then in effect 20% of the total loss realized on the puts will be recognized.

In the case of the taxpayer that owns 100,000 shares and buys puts covering 50,000 of those shares, the taxpayer could identify the straddle as consisting of the puts and 50,000 shares. The other 50,000 shares should not be treated as part of the straddle. To make it clear, the taxpayer could keep the additional 50,000 shares in a separate account from the other 50,000 shares and the puts. If the taxpayer then borrows against the account in which just the shares are held, then none of the interest expense should be capitalized.

So far, the examples have considered straddles consisting of non-Section 1256 contracts. Under Treasury Regulations section 1.1092(b)-3T, mixed straddles are those in which at least one, but not all, of the positions are Section 1256 contracts, the positions are identified no later than the day the Section 1256 contract is entered into, all of the positions are capital assets, and none are part of a larger straddle. Under IRC section 1256(a), gains and losses of Section 1256 contracts are treated as 60% long-term and 40% short-term capital, regardless of holding period. Section 1256 contracts must also be marked to the market at year end or—under IRC section 1256(c)—if delivery of the underlying property is either made or received. Of course, under IRC section 1222, the non-Section 1256 contracts are treated under the regular tax rules, meaning that the nature of their gains and losses is dependent on their holding periods. Gains and losses are not recognized until they are realized, and generally, all gains and losses of a short position are treated as short-term gains and losses under IRC section 1233(b)(1). Without making any identification of mixed straddles, most—if not all—of the gains from the positions will be treated as short-term while the losses will be treated as long-term.

There are a number of elections that taxpayers may make with respect to mixed straddles. First, under IRC section 1256(d), the taxpayer may elect to not have IRC section 1256 apply to all the Section 1256 contracts that are part of a straddle. In such cases, the straddle will be treated as consisting of only non-Section 1256 positions. None of the positions will be marked to the market and neither position will produce 60-40 gains or losses. This election is useful when a taxpayer is hedging an asset they wish to hold for a number of years with a Section 1256 contract because this allows for the gains and losses from both the asset and the Section 1256 contract that was used to hedge the asset to be recognized at the same time.

Taxpayers can identify mixed straddles on a straddle-by-straddle basis. Prior to Aug. 18, 2014, unrealized gains and losses were recognized at the time the mixed straddle was created under Treasury Regulations section 1.1092(b)-3T(b)(6). As long as the straddle was held open for at least 31 days, the losses were not disallowed under the wash sale rules. Previously, insurance companies used this rule to help utilize capital losses that they recognized in 2008 when they were forced to liquidate large positions in their bond portfolios. Subsequent to 2008, the insurance companies entered into mixed straddles with respect to bonds that had appreciated in value, which allowed them to utilize the loss—and in effect get a step up in basis in the bonds. It was easier to enter into a Section 1256 contract on bonds than to sell their portfolio and repurchase a new bond portfolio.

Under Treasury Regulations section 1.1092(b)-6, for mixed straddles established after Aug.18, 2014, pre-existing gains and losses are not recognized when the mixed straddle is created. Instead, the gains and losses are recognized at the time they would have been if the mixed straddle had never been put into place; however, their nature as either long-term or short-term is determined at the time the mixed straddle is created. Once the non-Section 1256 contract is made part of the mixed straddle, it will not begin to accrue holding period until the mixed straddle ceases to exist. In measuring the unrecognized gain in the non-Section 1256 contract at year end, both the unrecognized gain prior to the establishment of the straddle and post-establishment unrecognized gains are taken into account. Of course, if the Section 1256 contract was established prior to the straddle being created the pre-straddle gain or loss will be recognized at year end.

The following are examples from the Treasury Regulations  that show how these rules work.

1. A enters into a Section 1256 contract on Jan. 13, 2015. As of the close of the day on Jan. 15, there is a $500 loss on the contract. On Jan. 16, A enters into an offsetting non-Section 1256 position and makes a valid mixed straddle identification. A holds both positions until year end, and neither position has any other changes in value. On Dec. 31, 2015, the $500 loss is recognized and it is treated as 60% long-term and 40% short term.
   
   
2. On Dec. 3, 2014, A purchases a non-Section 1256 position for $100. At the close of Jan. 22, 2015, the position is worth $500. On Jan. 23, 2015, A enters into an offsetting Section 1256 contract and makes a valid mixed straddle identification. On Feb. 10, 2015, A closes out the Section 1256 contract for a loss of $500 and sells the non-Section 1256 position for a gain of $975. The $400 gain is recognized on Feb. 10 as a short term capital gain. The gain of $475 (975-500) is offset by the $500 loss on the Section 1256 contract. The $25 excess loss is treated as 60% long-term and 40% short-term since it is due to the Sec. 1256 contract.
   
   
3. On Aug. 23, 2014, A purchases 100 shares of index fund for $1,000. As of the close of the day on Sept. 3, 2015, the value of the shares is $1,200. A enters into a Section 1256 contract on Sept. 4, 2015 on the index referenced by the fund. A makes a valid mixed straddle election. On Dec. 31, 2015, the value of the shares of the fund are $1,450 and the Section 1256 contract has lost $300. On Jan. 10, 2016, A closes out the Section 1256 contract at a loss of $400 when the fair market value of the fund is $1,450. On Dec. 3, 2016, A sells the shares for $1,600.

2015: The $200 of pre-straddle gain will be treated as long-term at the time the shares are disposed of. On Dec. 31, the loss on the Section 1256 contract is netted against the $250 unrecognized gain on the fund. The $250 gain and the loss will each be treated as 60% long-term and 40% short-term. The entire $300 loss, however, will be deferred because the unrecognized gain on the fund shares includes both the pre-straddle gain and the straddle gain.

2016: When A closes out the Section 1256 contract on Jan. 10, 2016 the $300 loss is still deferred. On Dec. 3, A recognizes $200 of long-term capital gain from the pre-straddle period, $150 of long-term gain and $100 of short-term gain from the straddle period, and $150 of short-term capital gain from the post-straddle period. A recognizes the entire $400 loss from the Section 1256 contracts in 2016 because A no longer holds any positions that are part of a straddle. The net result is $110 of long-term capital gain and $90 of short-term capital gain.

An interesting result from the application of the rules is that from the time the straddle was entered into until all of the positions were closed, there was no economic gain or loss, but $200 of pre-straddle long-term gain was converted into $110 of long-term gain and $90 of short-term gain.

There is a potential trap for taxpayers who want to hedge their risk in holding an asset but don’t want to trigger the unrealized gain. They might consider hedging the asset with a Section 1256 contract and make a mixed straddle identification. While the mixed straddle rules will not cause the gain to be recognized, the constructive rules might. If the hedge completely removes all risk of loss and opportunity of gain on the hedged asset, the constructive sale rules under section 1259 will treat the hedged asset as if it were sold—and the gain would have to be recognized under IRC section 1259(a)(1). Further, under IRC section 1259(b)(1), neither the mixed straddle rules nor the constructive sale rules will cause any unrealized losses to be recognized at the time the straddle is created.

In order to avoid the recognition of gain, the Section 1256 contract that created the constructive sale would have to be closed prior to the thirtieth day after the tax year end in which it was established, and the underlying asset may not be hedged for the following 60 days under the rules of Section 246. Unfortunately, insurance companies can’t use the constructive sale rules to recognize the gains on bonds because bonds are not covered under IRC section 1259 unless they are convertible bonds.

In summary, taxpayers who enter into positions creating straddles can alleviate their precarious tax position by properly identifying the straddle.