BENEFITS FOR TRADERS ELECTING IRC SECTION 475
MARK-TO-MARKET ACCOUNTING TREATMENT
- The $3000 limitation on deductible capital losses does not apply. Trading losses are transformed into ordinary income which are fully deductible with no limitation
- Net operating losses can be carried back 2 years to offset prior years' income and to obtain a refund of taxes paid on income in prior years
- Net operating losses created by ordinary trading losses can be carried forward to offset future income
- Deferred losses on wash sales are fully deductible against gains and cumbersome record keeping requirements related to wash sales are eliminated
- Easier to segregate and report investment profits (potential long term capital gains) from trading profits by using separate accounts
Effect of §475 Election (Mark-to-Market accounting method)
The effect of making a §475 election is that by doing so, a trader is electing to utilize the "Mark-to-Market" method of (MTM) accounting method with regard to his/her securities or commodities positions. MTM is a method of accounting as are the "cash" method and the "accrual" methods with which many people are already familiar. The distinctions are as follows:
Cash: A tax payer who reports on a cash method accounts for income in the year received and expenses in the year paid.
Accrual: A taxpayer who reports on an accrual method accounts for income in the year in which s/he becomes entitled to receive payment and for expenses in the year in which s/he become obligated to make the payment.
Mark-to-Market: A taxpayer who elects to report on a Mark-to-Market method accounts for a gain or loss in his/her securities/commodities position as if the position was sold on the last business day of the year, whether or not it is actually sold.
Most individual Traders and all Investors are on the cash basis, and in fact this is the default accounting method which applies in the absence of a §475 election.
Example 1 - Cash method:
Tommy Trader is a cash basis taxpayer. On December 12, 1999 he bought 1000 shares of XYZ Corp. at a price of $12 per share for $12,000. On December 31 the shares have risen to $13 per share and his stake is worth $13,000. Believing the price will rise he holds his position until January 3, 2000 and sells for $13.50 a share, realizing a $1,500 gain. Since he did not sell until the following year the entire gain is reported on his 2000 tax return which he will file in 2001.
With the Mark-to-Market method, however, the stock/commodities are considered sold on the last business day of the year even if they are not actually sold. The market value of the security is determined by the market price on the last trading day of the year and a gain or loss is recognized based upon that price. Then on January 1, the stock is deemed to have a new cost basis which is the price at which the position was deemed sold.
Example 2 - Mark-to-Market method:
Using the same facts as above, if Tommy had made a Mark-to-Market election his positions would have been deemed sold on December 31 even though he continued to own the stock. As such he would be required to report a $1,000 gain on his 1999 tax return which he would file in April 2000. The adjusted basis of the stock would now be $13 per share. When he actually sells the stock on January 3 for $13.50 a share he would realize a $500 gain in 2000 which would then be reported on the tax return he will file in 2001.
Example 3 - Mark-to-Market method:
Using the same facts as above. If instead of the stock price rising what would happen if it dropped to $10 a share on December 31? In this case Tommy would have to realize a $2000 loss on his 2000 tax return even though he continues to own the stock and he would now have an adjusted basis of $10 per share. If he thereafter sells the stock for $10 per share on January 3 he would recognize neither a gain nor a loss in 2000. If the stock rebounds to $11 per share and he sells on January 3 he would then realize a $1,000 gain in 2000 which he would report on his tax return filed in 2001.
This is all that the §475 Mark-to-Market election does - it changes the accounting method for securities and commodities - IT DOES NOT DETERMINE TRADER STATUS. It should be noted, however, that while a §475 election does not determine Trader Status it is only available to Traders - not Investors. Note that the first sentence of §475(f) makes it available "[i]n the case of a person who is engaged in a trade or business as a trader in securities and who elects to have this paragraph apply to such trade or business…".
Traders | MTM Traders | Section 475 Election | Investors