Taxation: Notional Principal Contracts

Swaps are not § 1256 contracts. IRC §1256(b)(2)(B) expressly excludes interest rate, currency, basis, commodity, equity, equity index, and credit default swaps, together with interest rate caps and floors. So there is no mark-to-market, no 60/40, and no three-year carryback — none of the machinery in section “Section 1256 Contracts and the 60/40 Regime” applies. Swaps are taxed as notional principal contracts under Treas. Reg. §1.446-3, on a distinct set of rules:

Periodic payments accrue ratably

Under Treas. Reg. § 1.446-3(e)(2)(i), every taxpayer regardless of accounting method must recognize the ratable daily portion of each periodic payment for the taxable year to which it relates. You cannot time swap income by timing the payment date.

Nonperiodic payments spread over the term

An upfront payment — a cap premium, a prepayment — is recognized over the life of the contract in a manner reflecting its economic substance (§ 1.446-3(f)(2)), not deducted when paid.

Termination payments close it out

A payment to extinguish or assign the contract is recognized in the year of termination, together with any amounts not previously taken into account (§ 1.446-3(h)(2)).

Character is generally capital

IRC §1234A treats gain or loss from the termination of a right or obligation with respect to property that is (or would be) a capital asset as capital gain or loss. The periodic accruals, however, are ordinary.

The practical consequence for a taxable investor is unfavorable relative to futures: ordinary income on the periodic legs, no 60/40, and mandatory annual accrual whether or not cash arrived. If you are choosing between a swap and a futures position to achieve the same exposure, the futures contract wins on tax character for a U.S. taxable investor — see section “Fixed-Income Futures” for the financing comparison.