How Mark-to-Market Accounting Election Affects You
|What is Mark to Market (MTM)? A simple explanation would be that MTM is an accounting method that describes how a trader calculates their trading gains and losses, and how these gains and losses are reported on a trader’s annual income tax return. MTM refers to a year-end process where you mark all your open positions to market prices. Essentially, you are calculating the sale of all open positions at year-end using the closing price of the last day of trading in that year.
By default, securities and Section 1256 investors (Futures & Commodities) are stuck with capital-loss treatment, meaning they’re limited to a $3,000 net capital loss against ordinary income. The losses first offset capital gains in full without restriction. After the $3,000 loss limitation against other income is applied, the rest is carried over to the following tax years. This hurts traders’ ability to trade as their capital account is dwindled. It can take years or even a lifetime to use up their capital loss carryovers.
Only those who qualify as a trader in securities status could elect MTM to report their trading gains and losses. Those who qualify as investors are disqualified from electing MTM.
The IRC section 475 MTM basically allows traders to convert gains and losses from the capital gain treatment to ordinary income loss treatment. The MTM essentially cancels the need to report wash sale adjustments and allows a trader to claim any amount of loss in the year it occurred. Individual traders must make the election by April 15 for the current year. Failure to file the election by the deadline will cause the trader the ability to claim losses as ordinary and they will be stuck with capital loss carryovers.
Nuances & Misconceptions. There are many nuances and misconceptions about Section 475 MTM. For example, you’re entitled to have segregate investment positions that aren’t subject to Section 475 MTM treatment, meaning at year-end, you can defer unrealized gains on properly segregated investments. You can have both ordinary tax losses on business trading and deferral with lower long-term capital gains tax rates on segregated investment positions.
Another example would be that you can elect MTM for Equities only and not to include section 1256 contracts. This way you get to keep the preferential 60/40 tax treatment that applies to section 1256 contracts while enjoying MTM on equities.
Making the MTM election should not be done automatically, you should consider your status of capital carry forward losses (CFL) and, current year gain/loss as well as your projected gain/loss moving forward. Making the wrong decision could become very costly to traders.
Let’s explore a few examples:
You have a current CFL of $70,000, your capital gains as of March are $80,000. Making the MTM election for the current year will allow you to only claim $3,000 of the CFL while paying ordinary income tax on $80,000. Clearly, this will be unfavorable to you. If you are interested in MTM then a better choice would be to form a passthrough entity in April and continue to trade via that entity. A newly formed entity has 75 days from its inception to elect MTM. The result would be that the 80K YTD gains will be offset by the 70K CFL, leaving you with only 10K of taxable capital gains. All gains/losses from April moving forward will be considered ordinary.
Here’s another scenario.
You have a current CFL of $50,000, your capital losses as of March are $40,000. In this case you probably should make the MTM election, so you are not continuing to pile up more capital loss carryforwards. Electing MTM allows you to claim the full 40K in loss generated as of March. You could still choose to form a passthrough entity, and since you have more flexibility with the timing of the MTM you could still make the MTM election for the entity later in the year if needed. This way, if you generate profits in the April-Dec time frame you can stick with the default cash accounting method allowing you to offset any gains generated via the entity with 50K CFL. If you continue to have losses, you can then use the MTM election.
Using up capital-loss carryovers is a challenge for many traders. Proper Section 475 MTM election planning and entities are the answer. It pays to think out the nuances carefully and not make a blanket decision to skip Section 475 as that can cost you big time!
In general, securities traders should usually elect Section 475 MTM unless they already have significant capital-loss carryovers. On the other hand, if a trader generates large new trading losses before April 17, he or she might prefer to elect Section 475 MTM for the year in question by that sole proprietor election date to have business ordinary-loss treatment retroactive to Jan. 1. The trader can form a new entity afterward to use capital gains treatment and get back on track with using up capital loss carryovers. Alternatively, the trader can revoke the Section 475 election in the subsequent tax year.
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