After securing your trader tax status, the most important tax move a trader can make is to elect the mark-to-market accounting method. The mark-to-market method not only carries with it the considerable tax advantages described below, it also exempts you from the confusing and tedious wash sale rule.
Unfortunately, every tax year, many unsuspecting traders are surprised to find that they are unable to enjoy these tax advantages, and must instead file under the default cash method, because they did not elect the mark-to-market method in time.
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Here's a look at when and how to elect mark-to-market, and a brief overview of the benefits of doing so. But beware: mark-to-market may not be the best move for you. Consult with a Traders Accounting professional before making this important decision.
Deadlines and Procedures
The IRS may be somewhat vague about what constitutes trader tax status, but it is crystal clear when it comes to the deadline to elect mark-to-market: Individuals must make the election by April 15 of the current tax year - that is, to use MTM for your 2004 return, you would have had to elect mark-to-market by April 15, 2004. Calendar-year corporations must elect by March 15.
The lone exception is for what the IRS considers a new entity, such as a general or limited partnership, C corporation or limited liability company. As a new entity, you have 75 days to note your mark-to-market election internally in records or meeting minutes. You would then be entitled to use MTM for all trading activity from that point forward.
For individual traders, mark-to-market election is a two-step process. First, a statement of intent to use MTM must be filed by the April 15 election deadline. Second, a completed IRS Form 3115 (Application for Change in Accounting Methods) must be filed with your tax return for the change year.
You can file for an extension of up to six months to make your mark-to-market election via the private letter ruling procedure under IRS Section 301.9100-1 (Extensions of Time to Make Elections). The IRS may charge a fee for this. In practice, however, most traders who miss the MTM deadline don't realize it until the following year, and hence miss the election extension deadline as well.
Why Mark-to-Market Matters
Mark-to-market is the accounting method of choice for most active traders for the following reasons:
- No wash sales: MTM traders are exempt from the wash sale rule; because holdings are tallied at year's end, there is no need to account for gains or losses that might occur within the 30-day wash sale restrictions. Many traders elect MTM specifically to avoid cumbersome wash sale accounting.
- Loss insurance: Because your income/losses are treated as ordinary and not capital gains/losses, you are not bound by the $3,000 capital loss limitation. This means you can deduct all losses in the year they occur, providing tax relief when you need it most.
- No change to self-employment exemption: Even though MTM income is not considered capital gains, traders who elect MTM remain exempt from self-employment tax, the same as investors and non-MTM traders.
But there are disadvantages to making the mark-to-market election as well:
- No capital loss carryover: Capital losses can only be offset by capital gains. If you are carrying forward a substantial capital loss, beware: by selecting MTM, your gains would be considered ordinary income moving forward, hence only $3,000 per year could be used to offset your capital loss.
- Loss of long-term capital gains: Forex/futures traders who deal mainly with 1256 contracts typically avoid MTM in order to retain the advantageous long-term capital gains tax rate on 60% of their earnings.
- Election is permanent: As an individual trader, once you've made the MTM election, you're stuck with it. However, if you establish a legal entity, you may un-elect MTM if circumstances dictate, or simply dissolve and form another entity without electing
MTM.
Mark-to-market can be a trader's safety net. It can also, in some instances, be the biggest tax mistake you could make. Be sure to consult a Traders Accounting tax professional before making this all-important election.
Talk to you soon,
Jim Forrester
Traders Accounting
Jim Forrester, CPA is the
Tax Director of Traders Accounting, the nation's leading provider of
tax consulting, entity formation, tax preparation and 401(k)
services to the trading industry. Traders Accounting teaches traders
how to properly set-up their trading business and take advantage of
all the money-saving tax strategies available to home-based
businesses. Explore the website that Forbes has declared "Best
of the Web" for six straight years and find out exactly how to
make your trading into a 'business' and receive tax breaks and tax
deductions worth up to $25,000 each year. Visit www.tradersaccounting.com
for more info.
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