Taxes : Mark-To-Market Election

If you are a securities trader, you can make a “mark-to-market” election under section 475(f) of the tax code. Under this election, a trader reports all gains and losses from securities held in connection with a trading business as ordinary income (or loss), including securities held at the end of the year. Securities held at the end of the year are "marked-to-market" by treating them as if they were sold (and reacquired) at fair market value on the last business day of the year.

Generally, a securities trader has to make this election by the due date of the tax return for the year before the year in which the election becomes effective. In the year the election becomes effective, a trader reports all gains and losses from securities held in connection with the trading business, including securities held at the end of the year, in Part II of Form 4797.

If as a trader, you also hold securities for investment, you must identify those securities as investment securities in your records on the day they are acquired (for example, by holding the securities in a separate brokerage account). Securities held for investment are not marked-to-market.

Not Subject to Self-Employment Tax

Even though a trader is considered to be in the business of trading securities, gains or losses from the sale or disposal of securities are not taken into account when figuring net earnings from self-employment on Schedule SE. This is true regardless of whether a trader reports his or her gains and losses on Schedules D or Form 4797.

Investment Interest and Expenses

The limitation on investment interest expense that applies to investors (who must itemize deductions) does not apply to interest paid or incurred in a trading business. A trader reports interest and other expenses (except for commissions and other costs of acquiring or disposing of securities, which are used to figure the gain or loss) from a trading business on Schedule C (instead of Schedule A).

No wash sales. The wash sale rule doesn't apply to a trader who has made the mark-to-market election. There's a simple logic to this: if all your gains and losses are going to be flushed out on December 31, there's no reason for the tax law to be concerned about wash sales that may occur during the year.

Wash sales can be a significant headache for a trader even if they don't affect the amount of tax the trader has to pay. If you make hundreds of trades in the same stock, many of the trades are likely to result in wash sales. At some point, accounting for all the wash sales becomes nearly impossible. Eliminating this concern is a significant benefit of the mark-to-market election.

Ordinary income and loss. If you make the mark-to-market election, your trading gains and losses are converted to ordinary income and loss. You'll report the gains and losses on Form 4797 (sales of business property), not Schedule D (capital gains and losses).

This does not mean that your trading gains are now subject to self-employment tax. In a 1998 tax law, Congress clarified that although your trading income becomes ordinary income, it is not self-employment income. This also means you can't use this income to support a contribution to an IRA or other retirement plan.

Traders usually generate all or nearly all of their gains as short-term capital gains, which are taxed at the same rate as ordinary income. In most situations, changing to a system where the trader reports the gains as ordinary income will not have any tax cost. If the trader has capital losses from an investment that isn't part of the trading activity, though, the trader will lose the ability to offset those losses with capital gains from trading.

For many traders, the flip side will be more important. Even good traders sometimes have losing years. When they do, the capital loss limitation rears its ugly head. A trader who has not made the mark-to-market election can deduct only $3,000 of net capital loss, with the excess loss carrying forward only, not back to earlier, profitable years. If you make the election, your trading loss isn't subject to this limitation, and can carry back as well as forward. The difference can be huge.

You're Stuck With It

Once you make the election, you have to continue to use the mark-to-market method for all future years. You can change the election only with the consent of the Internal Revenue Service, and they generally won't grant this consent if your reason for changing is simply that the election didn't turn out to your advantage. Be sure you know what you're doing before making the election.