Hedging Versus Speculation

Published on: 19:43PM Feb 04, 2013

We got the following question from a reader today:

"I was wondering how to handle the purchase of corn options on your tax return?"

The answer is one of those "It depends" type answer.  If the farmer is purchasing an option for speculation, i.e. he purchases a corn call option, then he falls under the normal mark-to-market rules and will report any gain or loss under the special provisions of Section 1256. 

These rules call for 60% of the gain to be taxed at favorable long-term capital gains rates and 40% as short-term.  If the option is outstanding at year-end, it will be reported as if it was sold for the closing price and gain or loss will be recognized based on that price.

Capital gains are nice since they may be taxed at a lower rate.  Capital losses are not so nice since you generally can only deduct capital losses against capital gains plus $3,000 (this amount is not indexed for inflation and has been around for several years if not decades).  In some cases, you are allowed to carry back these types of losses to offset income from previous year(s) Section 1256 gains.

If the farmer is purchasing a corn put option as part of his hedging strategy, then the gain or loss is recognized only when he closes out the position and it is reported on his schedule F or other pertinent farm schedule.  Hedging gains or losses are alwasy treated as ordinary loss or income on the pertinent farm schedule.

Remember, if the farmer purchases a corn call option as part of this hedging strategy, this no longer qualifies as a hedge (even though is a normal strategy of selling actuals and buying the "board", for tax purposes, it is not a hedge)  and is considered speculation.  In many cases, the tax treatment can be harsh since if the option produces income, the IRS will treat it as ordinary and if it produces a loss, it will be considered a capital loss (the worst of both).

I would hazard a guess that if we "audited" a 100 farmer's hedging accounts, we would find at least one speculation transaction buried somewhere in each of them.  Do you have any?!