S. 4331 — Modernization of Derivatives Tax Act of 2026

This section designates the Act as the “Modernization of Derivatives Tax Act of 2026” and specifies that amendments refer to provisions of the Internal Revenue Code of 1986 unless otherwise provided.

This section establishes new rules under proposed IRC §491 for the tax treatment of derivatives and underlying investments upon a taxable event (i.e., termination or transfer of a derivative; sale or exchange of an underlying investment; or other events triggering gain or loss). It requires recognition of gain or loss in the year of the taxable event—generally determined at fair market value—with subsequent adjustments, treating such amounts as ordinary income or loss attributable to the taxpayer's trade or business (for purposes of IRC §§62(a) and 172(d)(4)) and sourced to the taxpayer's country of residence, incorporation, or organization. Special rules for investment hedging units (as defined in proposed §492) defer recognition of built-in losses on non-dispositive taxable events and treat built-in gains on underlying investments as long-term or short-term capital gain (as applicable); transition rules for REITs electing to include certain debt instruments in hedging units adjust built-in gain/loss calculations and treat certain capital loss carryovers as short-term capital gain.

This section excludes derivatives to which new §491(a) applies from the definitions of security (under §475(c)(2)) and commodity (under §475(e)(2)) subject to mandatory mark-to-market accounting for dealers and traders and makes conforming amendments to §475. This section replaces §1092 to defer recognition of losses on one or more positions to the extent such losses do not exceed unrecognized gains (i.e., built-in but unrealized gains as of year-end or realized but unrecognized gains) on offsetting positions (i.e., positions with a delta of -0.7 to -1.0, per §492(d)) with respect to applicable property (i.e., actively traded personal property described in specified paragraphs of §493(a), excluding derivatives as defined in §493). (Thus, disallowed losses carry forward to succeeding years, subject to the same offset limitation; taxpayers must report unrecognized gains to the Secretary, subject to waiver; and physically settled straddle positions are treated as terminated and repurchased at fair market value immediately before settlement.) The Secretary must prescribe regulations, including principles from prior wash sale (§1091) and short sale (§1233) rules.

This section repeals IRC §§1233, 1234, 1234A, 1234B, 1236, 1256, 1258, 1259, and 1260—rules governing capital gains and losses on options, straddles, securities transfers, regulated futures contracts (i.e., Section 1256 mark-to-market rules), and constructive sales—and makes conforming amendments to over 20 other IRC sections (e.g., §§475, 6045, 1058, 1091, 1221) to remove cross-references, update definitions (e.g., of "security" and "closing transaction"), and incorporate new derivative rules (e.g., §§491-493). It also adds a new Part IV to the table of parts for subchapter E of chapter 1, titled "Tax treatment of derivatives and similar contracts."

This section establishes effective dates for the bill's amendments, generally applying them after the 90-day period beginning on the date of enactment date of enactment. Specifically, (1) amendments made by section 2 apply to taxable events occurring after such period in taxable years ending thereafter; and (2) amendments made by sections 3 and 4 apply to derivatives and underlying investments held thereafter. Taxpayers holding derivatives and an underlying investment at the end of the 90-day period must identify any investment hedging unit under new IRC § 492(c)(2) before the period ends, with the first applicable hedging period for such a unit beginning the next day. (Thus, taxpayers have 90 days from enactment for transition compliance.)