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  Copyright© 1999 to 2011 Colin M. Cody, CPA and TraderStatus.com, LLC, All Rights Reserved.
 

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By "default" security traders are usually taxed under the oftentimes undesirable capital gains method of accounting, just the same as most other taxpayers.

But taxpayer businesses that maintain a complete and separable set of accounting books and records which qualify under IRS Regs. §1.446-1(d)(1) and that otherwise qualify to file with Trader Status may optionally elect in advance,
1 by a filing with the IRS, to irrevocably2 use as their accounting system the "Mark-to-Market" (M2M) method for the election year and all ensuing years, as described below. This accounting method treats what would normally be Schedule D "capital gains and losses" as Form 4797 "ordinary gains and losses."  The IRS expected approximately one thousand taxpayers to have made the election by year 20003. (the first and last year this information was made available)

I suspect that there have been many times those official M2M election numbers.  If there is a huge influx of M2M elections filed on self-prepared tax returns, it is very possible that the Internal Revenue Service will take a closer look at all returns electing M2M, and any resulting NOL carrybacks and especially those prepared by taxpayers without the benefit of professional guidance as evidenced by a "paid preparer" on the signature page.  Starting with the 2000/2001 tax filing seasons the Internal Revenue Service added information for securities traders in their filing forms instructions, publications (pdf), and on their FAQ web site.

It is also possible, but not necessarily probable, that due to widespread filing of defective as well as inappropriate M2M elections (by both self-preparers and by paid professionals) that there may be some relief offered to taxpayers to retroactively correct errors made. As of 2011, limited relief has been made available; to the contrary, the IRS and the Courts have strictly construed the election requirements.

Some other features of the Mark-to-Market election

Tax Summary of the §475(f)(1) election for Securities:
forgo making the election and...
Securities are
limited for deductibility of any trading losses if §475 M2M is not elected.        
Securities are subject to the Wash Sale Rule if §475 M2M is not elected.
Paper losses in securities held at year-end are not deductible if §475 M2M is not elected.
Paper gains in securities held at year-end are not
taxable if §475 M2M is not elected.
Gains in securities held over 12 months are taxed at long-term tax rates if
§475 M2M is not elected.
Substitute payment <46-day rule for short sales may cause certain short dividends to be not deductible if
§475 M2M is not elected.

make the election and...
Securities are not limited for deductibility of any trading losses if §475 M2M is elected.
Securities are
not subject to the Wash Sale Rule if §475 M2M is elected.
Paper losses in securities held at year-end are deductible if §475 M2M is elected.
Paper gains in
securities held at year-end are taxable if §475 M2M is elected.
Gains in securities held over 12 months are not taxed at long-term tax rates if
§475 M2M is elected.
Substitute payment <46-day rule for short sales generally has no effect if
§475 M2M is elected.
Old Capital Loss Carryforwards may be trapped on Schedule D if
§475 M2M is elected.



Tax Summary of the §475(f)(2) election for Futures/Commodities/§1256Contracts:
forgo making the election and...
§
1256 contracts have a nice long-term gain rate for 60% of gains if §475 M2M is not elected.
§1256 contracts are limited for deductibility of any trading losses if §475 M2M is not elected.

make the election and...
§1256 contracts have no long-term gain rate for 60% of gains if §475 M2M is elected.
§1256 contracts are not limited for deductibility of any trading losses if §475 M2M is elected.
Old Capital Loss Carryforwards may be trapped on Schedule D if §475 M2M is elected.



Trade both Securities and Futures/Commodities/§1256Contracts and you have a dilemma:
If you are guaranteed to be profitable in Futures/Commodities/§1256Contracts then the choice often is simple: Do not elect §475 M2M for Futures/Commodities/§1256Contracts.  You will be taxed at the favorable 60/40 tax rates.

The problem, the needed compromise, comes if there is a possibility that you might have a year with a loss in Futures/Commodities/§1256Contracts.
Example: consider making $400,000 in securities gains with §475 M2M and then losing $400,000 in futures with no §475 M2M - a potential disaster waiting to happen - $400,000 being taxed at your top income tax rate, and no current year deduction for $397,000 of the capital losses.
Avoid this possibility (and allow the $400,000 gain to be fully offset with the $400,000 loss) by electing §475 M2M now for Futures/Commodities/§1256Contracts - but then you would give up the special 60/40 taxation benefit that you would enjoy if you do not elect..




Trade (PTP) Publicly Traded Partnership securities and you can step into a vicious tax trap:
Most PTP do not elect M2M, therefore you may receive a Schedule K-1 with short-term or long-term capital losses or losses from §1256 Futures contracts.  Unless you happen to have capital gains to offset these types of losses, you may be limited to deducting no more than $3,000 per year.

Remember that if you have elected M2M for your own Securities trading and/or your own §1256 Futures contracts trading that the gains from those are ordinary gain, and therefore may not be offset against capital losses passed through the PTP.  Further, the PTP pass-through losses will reduce your tax basis in the security position held, resulting in an even larger taxable ordinary gain or a smaller tax-deductible ordinary loss.




Invest in hedge funds and pass-through entities, or have managed accounts and you may have a similar issue as with PTPs:
Many hedge funds,  and other pass-through entities may have capital gains/losses rather than ordinary gains/losses reported on their Schedule K-1s.  Likewise most managed accounts have capital gains/losses rather than ordinary.  If the net of all your trading and investing result in large capital losses after applying the wash sales rule, you may be limited to deducting no more than $3,000 per year.



Trading in Forex (which has its own tax elections for ordinary/capital tax treatment) and also trading Securities, (PTP) Publicly Traded Partnership securities and/or Futures/Commodities/§1256Contracts and you can really have a dilemma with very unfortunate income tax consequences:
Each of these four classifications of trading will result in gains and losses.  If the year ends with a net of capital losses, you may be limited to deducting a maximum of $3,000.  Any ordinary gains will then be taxed without the benefit of being offset by the year's capital losses in excess of that $3,000 amount.



Possible saving grace: a note on Limited Deductibility of trading losses if §475 is not made:
This can vary depending on the taxpayer, but generally for individuals Securities Losses may be offset against Capital Gains each year and if losses are greater, then an additional $3,000 is generally used to offset other income each year.  Any remaining is used as a capital loss carryforward year-to-year.

For Futures/Commodities/§1256Contracts the rules are similar to the above, but there is an optional election that can be made to carry the year's loss back three years to offset other Futures/Commodities/§1256Contracts gains that were taxed under the 60/40 tax rate.


What if you missed making a timely election?

Elections made for the year 2012

Elections made for the year 2011

Elections made for the year 2010

Elections made for the year 2009

Elections made for the year 2008

Elections made for the year 2007

Elections made for the year 2006

Elections made for the year 2005

Elections made for the year 2004

Elections made for the year 2003

Elections made for the year 2002

Elections made for the year 2001

Elections made for the year 2000

Elections made for the year 1999

Elections made for the year 1998

Elections made for the year 1997

Elections for years prior to 1997, the NOL,
"retroactive elections" and other special situations.


IRS reporting


1 Generally for individuals that means no later than April 15th for the year of the election (i.e. after the beginning and before the end of the year for which M2M takes effect).  For most corporations that means no later than March 15th for the year of the election. For new taxpayers, those who have not previously filed an income tax return (such as a newly formed multi-member LLC, for example) then that means #1 preparing the actual election statement no later than 2 months and 15 days after the entity's formation and #2 to notify the IRS that the election was timely made, the new taxpayer must attach a copy of the statement to its original federal income tax return for the election year (after the end of the first year).

2 In limited situations the §475(f) election may be revoked with the consent of the Secretary under §475(f)(3).
If a separately filing entity has made the election - in lieu of revocation the owners may simply stop using the entity, liquidate it or dissolve it.

3REG-104924-98 January 28, 1999 proposed Regs on Electing Mark-to-Market Accounting "[13] Estimated number of recordkeepers: 1,000."

   

 


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