One of the most important decisions you will make as a trader is whether to elect the mark-to-market (MTM) accounting method. Although MTM is only available to traders, not investors, and does offer some significant tax advantages, it is not right for everyone. What makes this decision so important is that once you select MTM, you’re stuck with it; there is no going back simply because it would be to your advantage tax-wise to do so.
Here is what you need to know about mark-to-market: how it works, advantages and disadvantages, the process to elect it, and how to separate and exempt long-term investments.
The MTM Method
Since 1997, mark-to-market accounting has enabled traders to change the tax status of their earnings from capital gains/losses to ordinary income/losses. This occurs on the last day of the year, at which time you tally all of your open holdings as if you were selling them at the market price that day (they are “marked to market”). On January 1st, you re-tally your holdings as if you were repurchasing them at the current price. The basis of each holding is then adjusted to reflect these hypothetical gains and losses for tax purposes.
Advantages of MTM
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. Favorable tax rate: Under MTM, income is taxed at a lower rate than capital gains. Losses are fully deductible: 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.
Disadvantages of MTM
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: A trader who deals mainly with 1256 contracts may not want to elect MTM because they would lose the 60% long-term capital gain on futures. Election is permanent: As an individual trader, once you’ve made the MTM election, you’re stuck with it. You can petition the IRS, but don’t expect leniency, especially if there is a tax advantage to you. However, if you establish a legal entity for your trading business first, you may un-elect MTM if circ*mstances dictate, or simply dissolve and form another entity without electing MTM.
How to Elect MTM
To elect mark-to-market as your accounting method, you must enclose a statement of intent with your tax return or extension request and file by the appropriate tax deadline (March 15 or April 15) the year prior to beginning MTM accounting. The one exception: if you’re filing as a new legal entity, such as an LLC, you have two months from opening to note your accounting preference in your meeting minutes.
Your first year using MTM, you will fill out IRS Form 3115 (Application for Change in Accounting Methods) and submit it with your tax return. This form contains an adjustment, Section 481(a), which captures duplications and omissions resulting from the change in accounting methods. If the adjustment is $25,000 or less, you may deduct the full amount on your return; if it exceeds $25,000, you may deduct 25% each year for the next four years.
Exempt Your Investments from MTM
Before you elect mark-to-market, be sure to separate your investment holdings from your trading stocks and options. Why? Because unless they are clearly separated, you will be required to mark them to market at year’s end and report any gain as ordinary income. That could prove disastrous for stocks that have greatly increased in value over the years.
The IRS lets you exempt your personal investments from your trading business, but only if you identify those investments up front. Like the MTM election itself, this designation is irrevocable; you cannot decide later to fold your investment losers into your trading stock for ordinary losses or cherry-pick your trading winners for capital gains treatment.
Under the IRS guidelines, you must clearly identify your investment stock as such in your records by the close of the day on which you acquired it or when the MTM election was made. There are two ways to do this: you may establish a separate account for your investment stocks (the wisest course of action for MTM traders), or simply note in your records which securities are not part of your trading business.
Be prepared to convince the IRS that your investments have “no connection” to your trading business; otherwise, you’ll be required to mark them to market at year’s end and report any gains as ordinary income.
Get Advice Before You Decide
Is the mark-to-market method right for you? Every trader faces different circ*mstances. For some, MTM is the obvious solution to the time-consuming task of tracking wash sales. For others, the ability to fully deduct their losses in the year they occur can make a big difference starting out. Oddly enough, traders who close their positions daily may not ever have to go through the MTM since there is typically nothing left at year’s end to reclassify.
If you find yourself carrying forward a capital loss or have other questions relating to mark-to-market accounting, be sure to visit Traders Accounting.
