In recent webinars and live events we have conducted, I often get questions about what the Mark to Market (MTM) accounting method (IRC Section 475 (f)) is and how electing MTM can affect your tax liability. 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 returns.
What is MTM? 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. In effect, you are reporting on your tax return all “realized” and “unrealized” gains and losses, so consequently, MTM converts unrealized positions to realized positions for tax purposes.
The default accounting method for all traders and investors is the cash method for both your trading gains and trading expenses. Only those who qualify as a trader in securities status have the ability to elect MTM to report your trading gains and losses. Those who qualify as investors are disqualified from electing MTM.
When to Elect MTM? You must elect MTM by April 15 of the current tax year. For 2011, you had to elect MTM by April 15, 2011 with the filing of your 2010 tax return or extension. For 2012, you can make the election by April 15, 2102 with the filing of your 2011 tax return. Changing your accounting method from cash to MTM will require you to file form 3115 Change of Accounting Method. The Change of Accounting Method is automatic and does not require consent from the IRS. Two steps are required in electing MTM. The first is electing it on time and the second is filing form 3115. Failure to file the election on time or in the proper fashion can result in substantial tax liability. You will also need to calculate and report section 481(a) adjustment on the form 3115 and on your tax return form 4797. Section 481 adjustment is your unrealized gain or loss on securities held in your trading business as of the end of the prior tax year; the reason being that cash method traders only report realized gains and losses in the prior year.
We strongly recommend using a professional accountant that specializes in tax trading rules to assist you on making the election (www.otataxpros.com).
One strategy to avoid the hard deadline of April 15 is to set up a corporation, or LLC, as they are considered to be “new” taxpayers and may elect MTM internally since they don’t have to file a tax return for the prior tax year. It’s important that you elect MTM properly since your entire tax loss insurance rests on this work.
What are the benefits of MTM? MTM trading gains and losses are considered ordinary gains and losses. This is an amazing benefit as it means that trading losses may be deducted in full against any type of income. Ordinary business losses can also generate net operating losses (NOL). NOLs may be carried back up to five years for immediate tax refunds using form 1045 or 1040X.
You are not limited by the $3,000 loss rule limitation that applies to cash method taxpayers and if you are new to trading, you may experience losses larger than $3,000 and you would like to be able to utilize all your losses in the year you incurred them so you can get your refund back from Uncle Sam fast enough to increase your reduced capital in your trading account.
Profitable traders may not be interested in the tax loss insurance that MTM provides so they are interested to know what benefit is there for them. The answer is that by electing MTM, they would be exempt from the burdensome wash sale loss deferrals rules that apply to non-MTM traders. For example, you may be profitable for the year, but have hundreds of wash sale transactions during the year. You would not be able to include those in your profit/loss calculation, thus increasing your tax liability substantially.
Should securities traders elect MTM? As you can see, MTM offers many advantages like deducting your trading losses as ordinary losses rather than restricted capital losses. Capital losses may not be carried back for individuals, but MTM can be carried back. MTM also offers a way out of dealing with wash sale rules, saving you time and money. Most securities traders should definitely elect the MTM accounting method.
MTM Bonus. If you have large unrealized losses on securities held going into 2012, elect MTM for 2012 by April 15, 2012. Your unrealized losses become part of your Section 481 (a) adjustment. This converts unrealized capital losses into ordinary losses. All first year Section 481 (a) adjustments are reported 100 percent in the year you convert from the cash method to the Mark To Market accounting method (IRC §475), and ordinary losses are much better than a large realized capital loss subject to the $3,000 annual loss limit.
Last Word. There are many nuances to electing MTM and strategies to consider. OTA Tax Pros has consulted with many traders and helped them with those nuances and strategies. We recommend consulting with an OTA tax pro professional on electing MTM. We can help you to make the right decision that fits your needs.
Be sure to visit our OTA Tax Pros website to find out how you can attend a free tax planning webinar.
– Michael Atias