Is there a place for derivatives in tax-loss harvesting?

Yes. As we discussed in Part I,[1] losses that are appropriate for tax-loss harvesting can be generated from a wide range of capital assets, including sales of stocks, debt securities, digital assets, real estate, or business sale proceeds. Ordinary income from items such as wages, salary, compensation, dividends, and interest can also be mopped up with ordinary losses in harvesting transactions.

The key objective in using derivatives alongside tax-loss harvesting is to maintain market exposure when closing out a loss position or deferring taxable income. Derivatives can also be used to avoid triggering the wash sales and tax straddle rules, while navigating other Internal Revenue Code (Code or I.R.C.) provisions that might otherwise apply.[2]

What are some of the risks in using derivatives with tax-loss harvesting?

The general risks I mentioned in Part III of this series also apply to strategies that incorporate derivatives.[3] Additional derivative-specific risks might include losses due to market volatility, illiquid positions (if not traded on an exchange), credit risk, and counterparty risk (if not guaranteed by a clearing organization). In addition, it is likely that these strategies will result in higher management fees and trading costs.

How can derivatives be used in tax-loss harvesting?

Certain derivatives can be marshaled in sophisticated ways when harvesting tax losses while investing in stock and securities (collectively, “securities”). One popular derivatives technique incorporates derivatives as an “overlay” to long-short portfolio strategies. This can help increase “tax alpha” (a measure of tax efficiency in the taxpayer’s portfolio) as I discussed in Part III.[4]

To achieve one of these stated objectives, a taxpayer might enter into a derivative to overlap (1) a long portfolio they believe will decline in value; or (2) a short portfolio they believe will increase in value. The derivatives overlay helps to insulate the portfolio from market losses. For example, a security might be sold at a loss and then a swap on that loss security entered into. The taxpayer can maintain market exposure to the loss security without needing to repurchase the security. The wash sales rule should not be triggered because a swap is not considered “substantially identical” to the loss security.

How do the wash sales rule and the tax straddle rules apply to tax-loss harvesting?

To briefly recap Part II of this series, the wash sales rule is a key consideration in tax-loss harvesting, documenting, and reporting transactions involving stock or securities.[5] It prevents taxpayers from taking a loss on securities if substantially identical securities are acquired within a 61-day window (starting 30 days before until ending 30 days after the loss sale).

The tax straddle rules have an even broader reach than the wash sales rule because they apply to “offsetting positions” in actively traded personal property—and, as such, they are not limited to stock and securities and cover all sorts of sales of personal property that are made at a loss. “Actively traded personal property” may include, for example, precious metals, foreign currencies, and commodities.

How do the tax straddle rules work?

The tax straddle rules, although difficult to apply, have three consequences. First, they prevent tax deductions from sales of “actively traded personal property” at a loss unless and until the taxpayer disposes of an offsetting gain position. “An “offsetting position” is a position that substantially reduces a taxpayer’s risk of loss from holding another offsetting (straddle) position.[6]

Second, any “interest or carrying charges” incurred to hold any straddle positions must be capitalized and added to the tax basis of the straddle position to which the interest or carrying charges relate.

And third, if a straddle position is held for less than the long-term capital gain holding period (currently set at more than one year) at the time the straddle is entered into, the taxpayer’s holding period in the securities position resets to zero and stays at zero until the straddle is closed out, and the holding period then starts over again.[7] The holding period reset can be an extremely nasty surprise for an uninformed taxpayer with a stock position held for less than the long-term holding period.

A taxpayer who owns stock (a long stock position) could establish a straddle by entering into any of the following offsetting (short) positions:

• selling a call option (the short call offsets the long stock position)
• buying a put option (the long put option offsets the long stock position—because the put is actually an option to sell the stock)
• entering into a collar transaction where the taxpayer buys a put and sells a call option on the same underlying stock (the long put offsets the long stock and the stock offsets the short call)

Positions are not offsetting unless they substantially diminish the taxpayer’s risk of loss in holding the offsetting position or positions. When the taxpayer holds offsetting positions, losses on the sale of an offsetting position are deferred until the offsetting gain positions are sold.

Do the tax straddle rules apply if the taxpayer sells call options on their stocks?

It depends. An important exception to the tax straddle rules is available to the taxpayer who sell calls that meet the “qualified covered call” (QCC) exception on stocks they own.

Calls are treated as QCCs if the taxpayer owns the underlying stock and sells a call on that stock with the option’s strike price set far enough above the stock’s market price that the taxpayer believes that the call option will not be exercised and thus expire worthless. A taxpayer enters into this classic buy-write strategy to generate some income from the premium received from the call option buyer, assuming that the call will expire worthless, and negating any need to deliver stock to satisfy the option buyer.

Code Section 1092(c) sets out the QCC requirements. QCCs are call options that meet two requirements. First, there are more than 30 days until expiration, and second, the call options are not deep in-the-money. This means that the call does not have a strike price lower than the “lowest qualified benchmark,”[8]–which, in general, means that if the call term is longer than 12 months, it needs to be priced above the previous day’s closing price (subject to some special rules); and if the call term is greater than 30 days but less than 12 months, it is likely to qualify if it’s price closes above the prior day’s closing price.[9]

Do the tax straddle rules apply to positions that offset securities portfolios?

Yes. The tax straddle rules can apply to a taxpayer who holds a portfolio of securities. For example, if the taxpayer sells an index option that is “substantially similar” to the securities in the portfolio, the tax straddle rules will apply.[10] If the short index position is not “substantially similar” to the stock portfolio, the taxpayer does not have a straddle so they can harvest losses by selling individual shares at a loss without deferring the losses under the tax straddle rules.

How does “substantially similar or related property” apply the tax straddle rules to a securities portfolio?

“Substantially similar or related property” is defined at Treasury Regulation Section 1.246-(5)(b) as “property” with a fair market value that (a) “primarily reflects” the performance of (1) a single firm or enterprise; (2) the same industry or industries; or (3) the same economic factor or factors, such as interest rates, commodity prices, or foreign currency exchange rates, and (b) changes in the fair market value of the stock are reasonably expected to approximate changes in the fair market value of the property.

Which derivative products are appropriate for tax-loss harvesting?

Popular derivatives include futures contracts, forward contracts, options, and swaps. Each of these products can be appropriate for tax-loss harvesting in certain circumstances. I will quickly run through each of them, below.

Futures contracts

Futures contracts that meet the “regulated futures contracts” (RFCs) definition, are subject to the special rules in Code Section 1256.[11] An RFC is defined as a contract (1) where the amount deposited and withdrawn depends on a system of marking-to-market, that is (2) traded on a “qualified board or exchange.” As a general rule, futures contracts traded on U.S. commodity exchanges that are registered with the Commodity Futures Trading Commission (CFTC)[12] meet this definition, and are taxed as RFCs.

RFCs, as types of “section 1256 contracts,” are subject to two special rules. First, section 1256 contracts that are capital assets in the taxpayer’s hands are taxed as 60 percent long-term and 40 percent short-term capital gain or loss.[13] Taxpayers receive 60/40 treatment without regard to the amount of time in which they hold the RFCs, that is, whether they hold them for one minute or more than a year.

Second, section 1256 contracts that are open on the last business day of the tax year are marked-to-market as if they were sold for their fair market value on that day.[14] All gains and losses on open RFCs are, therefore, reported in the same tax year as those that were closed out during the year. Because of this annual mark-to-market requirement, a taxpayer cannot take tax losses while deferring taxable income. In general, RFCs are not appropriate for tax-loss harvesting.

As actively traded personal property, RFCs are subject to the tax straddle rules. Losses will be deferred while the taxpayer holds an offsetting gain position in a straddle. A detailed discussion of the RFC tax rules is beyond the scope of this series. You can, however, refer to my financial products book if you are interested in learning more.[15]

Forward contracts

Forward contracts are bilateral contracts where one party agrees to deliver property or cash to the other party at a future date, according to agreed terms. In addition to the general risks I’ve already mentioned, two more risks are possible with forward contracts. First, because they are bilateral contracts, a taxpayer cannot close out a forward contract unless the other party agrees to an early termination that requires a payment to the party that is in-the-money so that party gets compensated for closing out a contract that has increased in value. Second, because these contracts are agreed directly between two parties, and they do not have a clearinghouse in the mix to become the buyer to all sellers and the seller to all buyers, the risk of one party defaulting and the other party not being able to secure immediate recourse can be higher.

Options contracts

The tax rules for options vary based on the type of option (put or call), the property underlying them, and whether the taxpayer is the seller (short position) or buyer (long position). In what follows I briefly discuss options on securities, commodities, and index options addressing how they can be used in tax-loss harvesting transactions.

Puts and calls

A call option gives the buyer the right—but not the obligation—to “call” the underlying property away from the seller to the buyer at the option strike price. A put option gives the buyer the right—but not the obligation—to “put” the underlying property to the seller at the option strike price.

If the taxpayer sells a call option, then they receive a premium to enter into the option and stand ready to deliver the underlying property if the option is exercised, no matter what is its market price at exercise. The seller of a put receives a premium and stands ready to buy the underlying property no matter the market price of the property at exercise.

With a call option, the seller is obligated to deliver the underlying securities at the strike price if the buyer exercises the call option. If the option holder sells a put option, they agree to buy the underlying securities from the put buyer at the strike price, no matter what the market price is at the time the buyer exercises the put option.

Securities Options

If an investor or trader buys a securities option (long position) and closes it out at a gain, the gain is long-term or short-term capital gain, depending on the taxpayer/buyer’s holding period. If the taxpayer sells an option (short position), gain or loss is always short-term, without regard to the taxpayer/seller’s holding period. If the taxpayer buys an option (long position) that expires unexercised, the taxpayer/buyer has a loss equal to the premium paid to buy the option.

Buyers of cash-settled options—that is, options that settle with a cash payment rather than a transfer of property[16]–are taxed based on the length of time the taxpayer/buyer held the option itself. Sellers of cash-settled option contracts, on the other hand, receive short-term capital gain or loss without regard to how long the taxpayer/seller held the short option position. For more information on the tax issues faced by investors entering into stock options, see my article, Taxation of Stock Options Held by Investors.[17]

Commodity options

Commodity options that trade on U.S. commodity exchanges are taxed as “nonequity options,” which are another type of section 1256 contract. Nonequity options are taxed the same way as RFCs as discussed in the futures contracts section above.

Commodity options that do not qualify as section 1256 contracts are taxed the same way as securities options as discussed in the securities options section above.

Index options

Taxpayers with a stock or commodity portfolio might enter into an index option that is similar—but not substantially identical—to the property held in their portfolio. This would allow the taxpayer/buyer to generate losses without triggering the wash sales rule. The tax straddle rules can apply to stocks that are “substantially similar or related property” to index options under the analysis at Treasury Regulation Section 1.246-5(b), discussed above.

Swaps contracts

Swaps are bilateral contracts entered into between two counterparties that agree to exchange payments based on an index or market price, as set out in the swap agreement. An equity swap or a total return swap can provide a taxpayer/buyer with exposure to the security that the swap notionally tracks. As a result, a taxpayer might sell stock at a loss and enter into a swap that replicates the economic exposure to the loss position. This could allow the taxpayer to report a tax loss without changing their market exposure.

Because swaps are bilateral contracts (as are forward contracts), there is the risk that the counterparty could default on the swap obligation and fail to pay the other party. In addition, counterparties can face unanticipated payment obligations triggered by adverse market movements.

Turning to applicable tax rules, a swap that provides for “periodic payments” and that also meets the other requirements set out at Treasury Regulation Section 1.446-3 are treated as “notional principal contracts” (NPCs). An NPC is a “financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts.”[18] An NPC is a unique financial product with unique tax rules. It is not taxed as a futures contract, forward contract, option, debt instrument, or section 1256 contract. Rather, the NPC tax rules turn on the type of payment involved: periodic, nonperiodic, or termination.

Periodic Payments

NPCs have payments that the counterparties exchange on a periodic basis.[19] They are taxed at ordinary income rates for all taxpayers, including investors and traders, even if the NPC is a capital asset in the taxpayer’s hands.

Nonperiodic Payments

A nonperiodic payment includes an upfront payment made to enter into an option-type NPC, such as a cap or a floor. Nonperiodic payments—like periodic payments—generate ordinary income and loss.

Termination Payments

A termination payment is one that is made only if the parties agree to terminate the NPC before its maturity date. To close out the swap, one counterparty would pay the other party an agreed amount based on the difference between the current market value and contractual obligations under the swap agreement. A termination payment ensures the “in-the-money” counterparty is made whole. The “out-of-the-money” party must pay the difference to the in-the-money party to reflect the economic advantage that the in-the-money party has secured by holding the appreciated swap agreement. Terminated payments generate capital gain or loss for investors and traders, or ordinary income or loss for dealers and hedgers.

Can a taxpayer apply ordinary income or loss from an NPC against ordinary losses or income from sources such as wages, salary, dividends, and interest?

Yes, with some limitations. Although most tax-loss harvesting transactions involve capital losses being used to mop up capital gains, ordinary losses can also be used to mop up ordinary income from sources such as salary, wages, compensation for services, interest, and dividends.

Certain tax rules can limit a taxpayer’s availability to utilize losses from NPCs, however. For example, deductions are limited if the taxpayer faces limitations under Code Section 212 (investment expenses); Code Section 1091 (wash sales); Code Section 1092 (straddles); or Code Section 1259 (constructive sales). Partners in partnerships must also consider whether the partnership is in a trade or business, a partner’s tax basis in their partnership interest, and the “at risk” rules. All of these tax provisions need to be considered when entering into NPCs.

The Golden Age of Crypto

My discussion about derivatives would not be complete without a note about the current golden age of crypto in the United States. Crypto derivatives are becoming increasingly important around the world, and in 2025 we have seen a range of crypto derivative products becoming available to trade on crypto platforms and regulated U.S. commodity exchanges. As crypto derivatives become increasingly available in the United States, it is worth noting that they may become useful in tax-loss harvesting transactions.[20]

[1] Q&A with Andie: Tax-Loss Harvesting, Part I: Overview, ASKramer Law LLC (Jul. 17, 2025), available at https://www.askramerlaw.com/publications/tax-loss-harvesting-part-i

[2] Q&A with Andie: Tax-Loss Harvesting, Part II: The Wash Sales Rule, ASKramer Law LLC (Jul. 25, 2025), available at https://www.askramerlaw.com/publications/tax-loss-harvesting-part-ii

[3] Q&A with Andie: Tax-Loss Harvesting, Part III: Investment Strategies, ASKramer Law LLC (Aug. 8, 2025), available at https://www.askramerlaw.com/publications/tax-loss-harvesting-part-iii

[4] Q&A with Andie: Tax-Loss Harvesting, Part III: Investment Strategies, ASKramer Law LLC (Aug. 8, 2025), available at https://www.askramerlaw.com/publications/tax-loss-harvesting-part-iii

[5] For a detailed discussion of the wash sales rules, see Q&A with Andie: Tax -Loss Harvesting, Part II: The Wash Sales Rule, ASKramer Law LLC (Jul. 25, 2025), available at https://www.askramerlaw.com/publications/tax-loss-harvesting-part-ii.

[6] I.R.C. § 1092.

[7] See I.R.C. § 1092(a). Tax straddles trigger other adverse tax consequences, such as interest on borrowings against the straddle being added to the cost basis of the stock, and potentially never being deductible under I.R.C. § 263(g). In addition, dividends received on straddled stock are taxed at ordinary income rates instead of at the favorable qualified dividend income rate available at I.R.C. §§ 1(h)(11) and 246(c).

[8] See I.R.C. § 1092(c)(4)(B).

[9] I.R.C. § 1092(c)(4)(C).

[10] See Treas. Reg. § 1.246-5(c)(1)(iii). This section provides specifics of how to identify a substantially overlapping portfolio that is determined based on a series of fair market value calculations.

[11] I.R.C. § 1256(g)(1).

[12] I.R.C. § 1256(g)(7).

[13] I.R.C. § 1256(a)(3).

[14] I.R.C. § 1256(a)(1).

[15] See Financial Products: Taxation, Regulation and Design, Andrea S. Kramer and Nicholas Mowbray (CCH, fourth edition, 2025 version), beginning with Section 69.02, for additional details. The book is available at https://shoptax.wolterskluwer.com/en/financial-pr-tax-reg-dsgn-2025.html, which some users claim is a ‘must have’ reference book in every well-appointed legal library.

[16] A cash-settled derivative is one where the underlying asset or Index does not exchange hands at settlement. Instead, one part compensates the other with a cash payment that is equivalent to the excess value of the position. As an example, suppose that a call option with a $50 strike price is exercised when the underlying equity price is $60. Rather than the option buyer giving the seller $50 in exchange for the physical share of equity, the seller agrees to simply pay the difference between the share price and the strike price, or $10, in cash. Special rules apply, for example, to short sales, puts, and written options.

[17] Taxation of Stock Options Held by Investors: What to Know, ASKramer Law LLC (Mar. 21, 2023), available at https://www.askramerlaw.com/publications/taxation-of-stock-options-held-by-investors-what-to-know

[18] Treasury Regulation 1.446-3(c).

[19] Treas. Reg. § 1.446-3.

[20] See our recent article for the Chambers and Partners Global Practice Guides, Capital Markets: Derivatives 2025, USA, Trends and Developments (Sept. 2, 2025), available at https://practiceguides.chambers.com/practice-guides/derivatives-2025/usa/trends-and-developments.