Options on MLPs are classified by my broker as section 1256 contracts. These MLP options do not settle for cash, they settle for units in the underlying MLP. Since they are classified by the broker as section 1256 contracts they do mark to market accounting on exercise.
When an MLP call is exercised only the amount paid for the MLP units it reported to the partnership. The option transaction is not reported to the partnership at all.
For example – I own a $2.50 Call on an MLP with a current price of $5.50. I paid $1.00 premium expense for the call a few months ago. The current “mark to market” value of the $2.50 call is $3.00. I exercise the call. The broker reports to the partnership that I purchase units of MLP for $2.50, and the broker reports nothing to the partnership about the call option.
What is “mark to market” tax accounting for this call exercise?
1-My broker’s opinion (on the 1099) is …..Mark to Market value = $3.00 (gain) - $1.00 premium paid (cost) = $2.00 section 1256 (gain) for each contract.
2-My opinion is … (Mark to Market value = $3.00 (gain) – MLP option (now worth zero) loss of $3.00) - $1.00 premium paid (cost) = $1.00 section 1256 (loss) for each contract.
I think since the MLP option does not settle for cash, the mark to market gain is offset by the equivalent loss of the option asset from the account, leaving the premium paid (or received) to be the section 1256 gain or loss.
The difference between the two opinions is whether or not the fact that the exercised call option has gone from it's pre-exercise value ($3.00) to it's post exercise value (zero) is part of the gain/loss calculation. Since the value of the options DOES NOT flow into the partnership units Cost Basis, I think the answer the loss of the option value MUST be part of the tax accounting.
Who is correct?
