My brokerage classifies Call options on Master Limiter Partnerships (MLP) as section 1256 contracts, and not as equity options. The tax treatment of section 1256 contracts and equity options is different.
If I exercise an "in the money" call on the MLP the section 1256 contract is "marked to market" in a taxable event.
For example, if I have paid $1.00 premium to buy a $2.50 call on the MLP, and today the MLP is worth $5.00, and I exercise the $2.50 call, I have a profit of ($5.00 - ($2.50 + $1.00)) = $1.50 per contract. This $1.50 per contract profit is immediately realized in the calendar year that the section 1256 contract is exercised.
My question is should the broker then adjust the "cost basis" of the partnership units which were purchased in the exercise to account for a) I paid $1.00 premium for the $2.50 call, and b) I have paid tax on the $1.50 profit already? If I paid $1.00 premium to purchase a $2.50 section 1256 contract call on an MLP, and the MLP is today $5.00, and I exercise the $2.50 section 1256 contract call on that MLP, what is my cost basis on the newly acquired units of the MLP?
I worry the broker will assign it a $2.50 cost basis, resulting in me being double taxed both when exercising the section 1256 $2.50 call, and when later selling the underlying MLP (unless the MLP receives a cost basis of $5.00).
Does anyone know how MLP call options (classified as section 1256 contracts) affect the cost basis of the underlying MLP when exercised? What is the formula?
Thanks in advance.
