Treasury Regulation §1.7704-3 contains some rules about the treatment of investment income as “qualifying income.”
- Income from the following financial instruments is included in the definition of qualifying income:
- Capital gain from the sale of stock (however, capital losses will be ignored in determining gross income);
- Income from holding annuities;
- Income from notional principal contracts, if the property, income, or cash flow that measures the amounts to which the partnership is entitled would give rise to qualifying income if held or received directly from the partnership; and
- Other substantially similar income from ordinary and routine investments to the extent determined by the IRS.
- The types of income above will not be qualifying if they are derived in the ordinary course of a trade or business of the partnership. For this purpose,
- If the partnership is a broker, market maker, or dealer of the asset, the income derived from the asset is considered derived in the ordinary course of business.
- If the taxpayer is a trader or investor of the asset, the income derived from it is not treated as derived in the ordinary course of business.
- In calculating gross income and qualifying income for the purpose
- Losses do not enter the computation. of §7704,
- Gain realized when an investment is marked to market will be considered qualifying income even though there was no actual sale or disposition.
- Gain recognized with respect to a capital asset will not fail to be qualifying income solely because it is characterized as ordinary income under Code section 475(f) (election of mark to market), 988 (foreign currency), 1258 (recharacterization of gain from certain financial transactions), or 1296 (election of mark to market for marketable stock.
- Special rules are provided for calculating gross and qualifying income where straddles (offsetting positions held in traded property so as to diminish risk) are involved.
- Two or more straddles that are part of a large straddle will be treated as a single straddle.
- For straddles other than mixed straddle accounts, the amount of gain taken into account is the amount by which any gain recognized during the tax year for property in that was in the straddle at any time during that year exceeds any loss recognized for property that was in the straddle at any time during the tax year (including previous tax years).
- For mixed straddle accounts (accounts established by a taxpayer for determining gains and losses from all positions held as capital assets in a designated class of activities) the amount of gain taken into account for each account is the annual account gain for that mixed straddle account, computed under Treas. Reg. §1.1092(b)-4T(c)(2).
- Arrangements similar to straddles. Interests in property that produce a substantial diminution of the partnership’s risk of loss similar to that of a straddle will be combined so that the amount of gain taken into account by the partnership in computing its gross income is the amount by which any gain recognized during the tax year with respect to the interests exceeds any loss recognized during the taxable year with respect to the interests.
- Wash sale rule—If a partnership recognizes gain in a “section 7704 wash sale transaction” with respect to one or more positions in either a straddle or an arrangement similar to a straddle, the gain will not be taken into account to the extent of the amount of unrecognized loss (as of the close of the tax year) in one or more offsetting positions of the straddle or arrangement. A “section 7704 wash sale transaction” is a one in which a partnership disposes of one or more positions of a straddle or similar arrangement and acquires a substantially similar position or positions within a period beginning 30 days before the date of the disposition and ending 30 days after the disposition.
Treas. Reg. §1.7704-3; I.R.C. §1092(c); Treas. Reg. §1.1092(b)-4T