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Mark to Market Election
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Mark-to-Market Tax Election For Securities (Not Commodities) in the United States One benefit of being a trader in securities is the ability to elect the Mark-to-Market (MTM) method of accounting. The tax election is available to an active trader and not to an investor in securities. The election is available for individuals and entities that file U.S. tax returns. Need a Sample Mark-to-Market Election? Contact Us
Note that a person or entity trading mainly in 1256 contracts typically would not want to make the MTM election because that person would lose the 60% long-term capital gain treatment available for futures trading subject to the 1256/commodities tax rules.
Should I Consider a MTM Election? Only someone who qualifies as an active securities trader can elect MTM treatment. If you elect MTM tax treatment, it results in a "deemed" sale of your open securities positions on the last business day of the taxable year. The term "mark-to-market" refers to when all open positions are marked to fair market value at year end. In effect a sale of all open positions (long and short) is triggered for tax purposes at year end using the year end market prices. On the first day of the following year those positions are bought back for the same market value. If you make the election and have a security that has gone down in value, you will recognize a loss on that security. If you have a security that has gone up in value, you will recognize a gain on that security. Your tax basis/cost in that security is adjusted up or down to reflect the gain or loss that you recognize on your tax return.
This tax treatment flushes out all realized and unrealized gains and losses for U.S. tax reporting purposes. The mark to market tax election applies only to trading gains and losses and not to business expenses. An active trader may elect MTM for trading gains and losses and use the accrual or cash method of accounting for business expenses.
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There are many other important things to know about the mark to market tax election.
Change in Tax Character of Gain or Loss
The MTM election changes the character of a trader’s gains or losses from capital gain or loss to ordinary income or loss. For a trader who makes the election, the $3,000 capital loss limitation no longer applies.
Wash Sale Rule No Longer Applies
Once the mark to market election is made, the wash sale rule no longer applies. That could be a huge benefit for a trader with a large number of repetitive trades in the same securities.
The Election is Permanent
The MTM election is a permanent choice. Once it is made, it cannot be withdrawn without IRS consent.
No Self Employment Tax Impact
Mark to market election does not trigger self-employment taxes on the trader’s income.
Pre-Election Trading Concerns
Once elected, you will no longer have capital gains or losses as all the gains or losses will be characterized as ordinary. If you have a large capital loss carry forward you would not want to elect mark to market accounting as ordinary income cannot be used to offset the capital loss carry forward.
Our Customers Thank you - Money Science Your explanation of how to start a hedge fund is so clearly stated and easily understood. This should be a chapter in a high school text book or at least minimum college reading. I read it with interest in potentially starting my own hedge fund. I fall within the scope of "Hedge Fund Incubator". I know this article is a few years old but again well worth reading. I may seek your services and have since bookmarked your page. Thank you again. Jxxx Xxxxx January 6, 2012
Futures contracts (such as most index options) in mark-to-market accounts are still entitled to special tax treatment and should be excluded from the scope of the mark to market election. Mark to market is not a preferred accounting method for profitable commodities and futures traders. The reason is that the default tax rules allow for 60% long term and 40% short term capital gain. As a result, the maximum blended tax rate on commodities and futures is 23% versus 35% on securities.
Electing mark to market accounting converts commodities and futures trading capital gains and losses (60/40 treatment) to ordinary gain and loss treatment (a 12% tax rate increase). However, if you have large commodity trading losses before April 15 of the current year, electing mark to market accounting will allow the trading losses to be treated as ordinary.
Strategies for Making the Mark to Market Election As the election is specific to the active trader, it is best made by an entity, rather than an individual taxpayer. An S corporation is easier to liquidate than an individual. The individual unhappy with his or her election needs to cease trading activities and become inactive (trading in the interim should be conducted through an entity) so that trading status lapses.
Make sure you (or your entity) are an active securities trader. There is no bright line test for trader versus investor status based on what little legal precedent exist. Make sure you have significant portfolio turnover on an annualized basis. Other factors (use of a margin account, options, futures, and short selling) can support active trader status.
Mechanics of the Mark to Market Election
The mechanics of taking the election involve both the timing and certain required paperwork. The election needs to be made by the due date (without regard to extensions) of the original federal tax return for the taxable year immediately preceding the year in which the election is to be effective (the “election year”). Hence if a taxpayer wants the MTM to be effective for tax year 2013 (the election year), then the election needs to be made by the due date of the 2013 tax return—April 15, 2013. The election must either be attached to that return or to a timely-filed request for an extension of time to file that return.
Miss the Mark to Market Election?
If a taxpayer blows the timing requirement, then the mark to market election is not available for that desired election year. One way around the timing problem is to form a legal entity from which to trade, such as a LLC. For a new trading entity, you must elect within 75 days of the start of trading activities, and then include the election in the entity's first tax return. If your mix of positions includes both active trading and buying some positions (or taking some shorts), for the longer term you should establish an investment securities account. This account can be at the same brokerage where your active trading account is maintained.
Paperwork for the Mark to Market Election
Attach a written statement to the tax return that provides the following information: the election being made, the first taxable year for which the election is effective, and the trade or business for which the election is made. An existing taxpayer must file a Form 3115, Application for Change in Accounting Method. This Form 3115 must be attached to the taxpayer’s timely filing (including extensions) return for the year of change.
Identification of Securities Not Subject to the Election
While a trader generally holds securities to capture short term market swings, a trader may nevertheless hold some securities for long term appreciation as an investment. In that circumstance, there is an exception to the market to market election if the taxpayer has clearly identified the investment securities in the trader’s records before the close of the day on which the investment security was acquired or the date the mark to market election was made. You have to be able to demonstrate by clear and convincing evidence that the securities have no connection with his or her trading business. If the electing trader holds an investment security and is also trading in the same or substantially similar security, the identification is not effective unless the investment securities are held in a separate non trading account maintained with a third party.
There are two ways to make the exemption identification. The first is to establish a separate brokerage account for investment securities. The second way is to indicate on your own records which securities are not part of your trading business.
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Reporting Trading Income Under Mark to Market Election
Prior to the mark to market election, gains and losses would have gone on Schedule D, Capital Gains and Losses. Now such gains and losses are not capital but they are are ordinary and reported on Form 4797, Sales of Business Property. Each trade is listed under Part II, Ordinary Gains and Losses. Expenses are reported on Schedule C, Profit or Loss From Business.
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