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Trading Tips and Strategies from Traders at DaytradeTeam
Monday, August 15, 2005
Mark-to-Market Accounting for Options Traders
Taking Advantage of the Mark-to-Market Accounting Election
Since 1997, the tax law has permitted active traders to elect a method of accounting called the mark-to-market method. This is one of the most important decisions you`ll make as a trader and your decision carries great ramifications, so don`t take it lightly. The rules are fairly complex and will be completely new to most traders. It`s important to read this article thoroughly, and then consult with a knowledgeable tax professional before making your decision. Many active traders such as those on the Options trading Systems find this election attractive as a way to make filing simpler and possibly to reduce their taxes.
Mark-to-Market Election
If you`re a trader, you may choose whether or not to make the mark-to-market election. You aren`t granted mark-to-market treatment automatically when you file as a trader. And you can`t elect this treatment if you aren`t a trader.
Your mark-to-market election must be filed by the return due date - without extensions - for the year before the year you want the election to be effective. The last day to file your election for the year 2003 was April 15, 2003. If you want to play by the mark-to-market rules in 2004, make your election by April 15, 2004.
Consequences of the Mark-to-Market Election
Marking to market - The most obvious consequence of the election is that at the end of each year you must mark your securities to market. What this means is that you treat any stocks you hold at the end of the day on December 31 as if you sold them on that day for the current market value. If the stock has gone down, you report a loss without actually selling it. If the stock has gone up, you report that gain. Your stock basis on January 1st is adjusted to reflect the gain or loss you report so you don`t report the same gain or loss again when you actually sell the stock.
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. For those of you who are investors and non-mark-to-market traders, the wash sale rule is a cumbersome accounting imperative, which says, in a nutshell, that if your sell a security (or option) at a loss, and buy that same security (or option) within 30 days before or after the original sale date, you can`t reduce your taxable income by the loss amount.
If you`re a trader, wash sales can be a significant headache even if they don`t affect the amount of tax you have 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 your trading gains are now subject to self-employment tax. In a 1998 tax law, Congress clarified that although the mark-to-market election means 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 to be short-term capital gains, which are taxed at the same rate as ordinary income. In most situations, changing to a system where you report your gains as ordinary income will not affect your tax bill. If you have capital losses from an investment that isn`t part of your trading activity though, you`ll lose the ability to offset those losses with capital gains from trading.
For many traders, the flip side will be more important. Even if you`re a good trader, you`ll sometimes have losing years. When you do, the capital loss limitation rears its ugly head. If you`re a trader who has not made the mark-to-market election, you 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 in your tax bill can be huge.
One word of caution for futures and commodity traders: by electing mark-to-market accounting you will lose the 60% long-term capital gain or loss treatment you receive when you trade these types of securities.
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 their consent if your reason for changing is simply that the election didn`t work out to your advantage. Be sure you know what you`re doing before making the election.
Identifying Holdings
Before you make the mark-to-market election, identify any stocks you hold as an investment. Failure to do so could be costly.
What`s at Stake - Suppose you`re a trader and you make the mark-to-market election. In addition to stocks you trade, you hold some stocks as investments. In fact, you might have held some of these stocks for years, and they`ve gone up in value a great deal. If these stocks are consideredpart of your trading business, you`ll report ordinary income, not capital gain, when you sell them. Even if you don`t sell them, the gain will be treated as ordinary income when you mark to market on December 31. Depending on how much your investment stocks have appreciated, this could be a real disaster.
What You Can Do - The rules let you maintain investments that are not part of your trading business. To do this, you have to identify those investments clearly. In other words, you have to make it clear, up front, which stocks are part of your trading business and which are not. You can`t decide later to treat your investment losers as trading stocks (for ordinary losses) and your winners as investment stocks (to avoid marking to market and getting capital gain treatment).
When to Identify - The proposed regulations provide that if you want to identify securities as not being part of your trading business, you must do so on the same day you acquire the security (or enter into or originate your position in the security, in the case of short positions or options). If you hold any investment securities at the time the mark-to-market election becomes effective, presumably you can identify them at that time.
How to Identify - Regulations developed for securities dealers provide two ways to identify securities for the purposes of these rules. One is to establish a separate account for investment securities, and the other is to clearly indicate on your own records which securities are not part of your trading business.
These rules also apparently apply to securities traders. There`s some question in my mind, however, whether identifying shares on internal records makes sense for an individual trader. It will be difficult to establish factually that the identification was made when it should have been, rather than being made up later. For this reason, I recommend that anyone who makes the mark-to-market election and holds some securities for investment should establish separate accounts for trading and investment activities, taking care never to mix the activities of the two accounts.
No Connection to Trading Business - Even if you identify securities as investment securities, the IRS can disregard your identification unless you demonstrate by "clear and convincing evidence" that the security has "no connection" to your trading activity. If the IRS rejects your identification, you`ll be required to mark the securities to market at the end of the year, and report any gain as ordinary income. It isn`t clear to me what is meant by "no connection" to the trading business. In particular, it isn`t clear whether investment securities can be used as collateral for trading margin without being drawn into the mark-to-market regime.
Making the Mark-to-Market Election
Many elections under the Internal Revenue Code are as simple as putting a checkmark in the proper box. That isn`t the case for the mark-to-market election. In fact, making the election is a royal pain.
Deadline - The IRS chose an unusual deadline for this election. Most elections are due at the end of the year, when you file your return. This election has to be made by the due date ? without extensions ? for the previous year`s tax return. The last day to make the mark-to-market election for the year 2004 was April 15, 2004.
I believe the main reason for this is to prevent taxpayers from choosing the election at a time when they already know whether their trading activity will generate a profit or a loss. Many traders would wait until they are faced with a year with significant trading losses, and then file the election for that year to avoid the capital loss limitation. Of course you`re stuck with the election for all future years once you make it, but until then, you get the benefit of capital gain treatment in profitable years without worrying about the capital loss limitation in a year with poor results.
There`s a rule that says a "new taxpayer" (a taxpayer for which no federal income tax return was required for the preceding year) can make the mark-to-market election during the first two months and 15 days of the election year. If you`re a new taxpayer, you`ll make your election by recording it in your books and records rather than by filing an election with the IRS. It appears that this rule was designed for newly formed entities (such as corporations and partnerships). Individuals who start trading after April 15 without forming an entity will apparently have to wait until the following year to make the mark-to-market election.
Making the Election - Making the election is a two-step process (with the second step being in two parts). The first step is to file an election, on or before the unextended due date of your tax return for the year before the year to which the election applies. If you file your tax return by the regular due date, attach the election to your tax return. If you file for an extension, attach the election to your extension request.
Note: You may read elsewhere (as I have) that this election may be filed by itself. The IRS clearly states that the election must be attached to the return or the extension request.
Note: If you filed early you can still make the election if you act by the due date of your return. File an amended return with the election attached.
Here`s what an election would look like, assuming it applies beginning in the year 2003 and that it is filed with the original return, not with an extension or amended return:
John Doe SSN 555-55-5555 Attachment to 2003 Form 1040
I hereby elect to use the mark-to-market method of accounting under section 475(f) of the Internal Revenue Code for my trade or business of trading securities. The first year for which the election is effective is the taxable year beginning January 1, 2003.
_____________________John Doe
Make appropriate changes if the form is filed for a different year or if it is attached to Form 4868 (individual extension request) instead of Form 1040. IRS guidance doesn`t seem to require a separate signature on this statement but I feel more comfortable including it.
Form 3115 -When you file your return for the year the election is effective, you need to attach Form 3115, an Application for Change in Accounting Methods. You also have to send a copy of Form 3115 to the IRS national office. Because Form 3115 is a concoction of arcane questions, I highly recommend you consult with a tax professional who can help you complete the eight-page Form.
The Section 481(a) Adjustment
There`s an arcane aspect of the mark-to-market election that confuses many people, including knowledgeable tax professionals. The question is what you report as the section 481(a) adjustment when you file Form 3115 for the mark-to-market election. Here`s an explanation of this adjustment.
Purpose of the Adjustment - When you change your accounting method, it`s possible you`ll have some items that are either duplicated or omitted because they`re treated differently under the two accounting methods. For example, suppose you switched from cash accounting to accrual accounting at the end of 2002. In January, 2003 you paid an expense that relates to the previous year. You can`t deduct this amount under the cash method in 2002 because you didn`t pay it that year. Likewise, you can`t deduct it under the accrual method in 2003 because it relates to the previous year. The section 481(a) adjustment allows you to correct this type of problem. In this case, the adjustment would be an added deductionto make up for the fact that this item fell between the cracks when you changed your method of accounting.
Calculating the 481(a) Adjustment - The mark-to-market election requires you to treat the securities in your trading account as if you sold them for fair market value on the last day of the taxable year, with and resulting gain or loss reported as ordinary income or deduction. Under this method of accounting, you`re treated as if you sold your trading securities for fair market value at the end of the year. Your basis for the securities is adjusted for any gain or loss, with the result being that basis equals year-end value for any securities held at the end of the preceding year.
For the last year before the mark-to-market election takes effect, you`re still using the normal tax rules to report gain or loss. You don`t treat your securities as sold on the last day of the year. Yet under the mark-to-market system, which you`re using as of the beginning of the next year, your basis is equal to the value of the securities at the end of the preceding year. That creates the potential for duplication or omission of gain or loss.
Example: At the end of 2000 you held shares with $24,000 basis but value of $26,000. You made the mark-to-market election effective beginning in 2001, and ended up selling these shares for $30,000. You report $4,000 of gain on the sale of the shares, and in addition you have a $2,000 section 481(a) adjustment.
If you held securities at the end of the year preceding your first year using the mark-to-market method, your adjustment is the difference between the value of those securities at the end of the year and your adjusted basis for the securities. Tax professionals looking for authority on this point should review Rev. Rul. 93-76. Although this ruling deals with dealers rather than traders, it explains how the section 481(a) adjustment works in connection with a change to mark-to-market accounting.
*If you would like to learn more about how to properly set-up a trading business, and all of the tax strategies available to you, check out the Traders Accounting homepage.
Since 1997, the tax law has permitted active traders to elect a method of accounting called the mark-to-market method. This is one of the most important decisions you`ll make as a trader and your decision carries great ramifications, so don`t take it lightly. The rules are fairly complex and will be completely new to most traders. It`s important to read this article thoroughly, and then consult with a knowledgeable tax professional before making your decision. Many active traders such as those on the Options trading Systems find this election attractive as a way to make filing simpler and possibly to reduce their taxes.
Mark-to-Market Election
If you`re a trader, you may choose whether or not to make the mark-to-market election. You aren`t granted mark-to-market treatment automatically when you file as a trader. And you can`t elect this treatment if you aren`t a trader.
Your mark-to-market election must be filed by the return due date - without extensions - for the year before the year you want the election to be effective. The last day to file your election for the year 2003 was April 15, 2003. If you want to play by the mark-to-market rules in 2004, make your election by April 15, 2004.
Consequences of the Mark-to-Market Election
Marking to market - The most obvious consequence of the election is that at the end of each year you must mark your securities to market. What this means is that you treat any stocks you hold at the end of the day on December 31 as if you sold them on that day for the current market value. If the stock has gone down, you report a loss without actually selling it. If the stock has gone up, you report that gain. Your stock basis on January 1st is adjusted to reflect the gain or loss you report so you don`t report the same gain or loss again when you actually sell the stock.
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. For those of you who are investors and non-mark-to-market traders, the wash sale rule is a cumbersome accounting imperative, which says, in a nutshell, that if your sell a security (or option) at a loss, and buy that same security (or option) within 30 days before or after the original sale date, you can`t reduce your taxable income by the loss amount.
If you`re a trader, wash sales can be a significant headache even if they don`t affect the amount of tax you have 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 your trading gains are now subject to self-employment tax. In a 1998 tax law, Congress clarified that although the mark-to-market election means 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 to be short-term capital gains, which are taxed at the same rate as ordinary income. In most situations, changing to a system where you report your gains as ordinary income will not affect your tax bill. If you have capital losses from an investment that isn`t part of your trading activity though, you`ll lose the ability to offset those losses with capital gains from trading.
For many traders, the flip side will be more important. Even if you`re a good trader, you`ll sometimes have losing years. When you do, the capital loss limitation rears its ugly head. If you`re a trader who has not made the mark-to-market election, you 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 in your tax bill can be huge.
One word of caution for futures and commodity traders: by electing mark-to-market accounting you will lose the 60% long-term capital gain or loss treatment you receive when you trade these types of securities.
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 their consent if your reason for changing is simply that the election didn`t work out to your advantage. Be sure you know what you`re doing before making the election.
Identifying Holdings
Before you make the mark-to-market election, identify any stocks you hold as an investment. Failure to do so could be costly.
What`s at Stake - Suppose you`re a trader and you make the mark-to-market election. In addition to stocks you trade, you hold some stocks as investments. In fact, you might have held some of these stocks for years, and they`ve gone up in value a great deal. If these stocks are consideredpart of your trading business, you`ll report ordinary income, not capital gain, when you sell them. Even if you don`t sell them, the gain will be treated as ordinary income when you mark to market on December 31. Depending on how much your investment stocks have appreciated, this could be a real disaster.
What You Can Do - The rules let you maintain investments that are not part of your trading business. To do this, you have to identify those investments clearly. In other words, you have to make it clear, up front, which stocks are part of your trading business and which are not. You can`t decide later to treat your investment losers as trading stocks (for ordinary losses) and your winners as investment stocks (to avoid marking to market and getting capital gain treatment).
When to Identify - The proposed regulations provide that if you want to identify securities as not being part of your trading business, you must do so on the same day you acquire the security (or enter into or originate your position in the security, in the case of short positions or options). If you hold any investment securities at the time the mark-to-market election becomes effective, presumably you can identify them at that time.
How to Identify - Regulations developed for securities dealers provide two ways to identify securities for the purposes of these rules. One is to establish a separate account for investment securities, and the other is to clearly indicate on your own records which securities are not part of your trading business.
These rules also apparently apply to securities traders. There`s some question in my mind, however, whether identifying shares on internal records makes sense for an individual trader. It will be difficult to establish factually that the identification was made when it should have been, rather than being made up later. For this reason, I recommend that anyone who makes the mark-to-market election and holds some securities for investment should establish separate accounts for trading and investment activities, taking care never to mix the activities of the two accounts.
No Connection to Trading Business - Even if you identify securities as investment securities, the IRS can disregard your identification unless you demonstrate by "clear and convincing evidence" that the security has "no connection" to your trading activity. If the IRS rejects your identification, you`ll be required to mark the securities to market at the end of the year, and report any gain as ordinary income. It isn`t clear to me what is meant by "no connection" to the trading business. In particular, it isn`t clear whether investment securities can be used as collateral for trading margin without being drawn into the mark-to-market regime.
Making the Mark-to-Market Election
Many elections under the Internal Revenue Code are as simple as putting a checkmark in the proper box. That isn`t the case for the mark-to-market election. In fact, making the election is a royal pain.
Deadline - The IRS chose an unusual deadline for this election. Most elections are due at the end of the year, when you file your return. This election has to be made by the due date ? without extensions ? for the previous year`s tax return. The last day to make the mark-to-market election for the year 2004 was April 15, 2004.
I believe the main reason for this is to prevent taxpayers from choosing the election at a time when they already know whether their trading activity will generate a profit or a loss. Many traders would wait until they are faced with a year with significant trading losses, and then file the election for that year to avoid the capital loss limitation. Of course you`re stuck with the election for all future years once you make it, but until then, you get the benefit of capital gain treatment in profitable years without worrying about the capital loss limitation in a year with poor results.
There`s a rule that says a "new taxpayer" (a taxpayer for which no federal income tax return was required for the preceding year) can make the mark-to-market election during the first two months and 15 days of the election year. If you`re a new taxpayer, you`ll make your election by recording it in your books and records rather than by filing an election with the IRS. It appears that this rule was designed for newly formed entities (such as corporations and partnerships). Individuals who start trading after April 15 without forming an entity will apparently have to wait until the following year to make the mark-to-market election.
Making the Election - Making the election is a two-step process (with the second step being in two parts). The first step is to file an election, on or before the unextended due date of your tax return for the year before the year to which the election applies. If you file your tax return by the regular due date, attach the election to your tax return. If you file for an extension, attach the election to your extension request.
Note: You may read elsewhere (as I have) that this election may be filed by itself. The IRS clearly states that the election must be attached to the return or the extension request.
Note: If you filed early you can still make the election if you act by the due date of your return. File an amended return with the election attached.
Here`s what an election would look like, assuming it applies beginning in the year 2003 and that it is filed with the original return, not with an extension or amended return:
John Doe SSN 555-55-5555 Attachment to 2003 Form 1040
I hereby elect to use the mark-to-market method of accounting under section 475(f) of the Internal Revenue Code for my trade or business of trading securities. The first year for which the election is effective is the taxable year beginning January 1, 2003.
_____________________John Doe
Make appropriate changes if the form is filed for a different year or if it is attached to Form 4868 (individual extension request) instead of Form 1040. IRS guidance doesn`t seem to require a separate signature on this statement but I feel more comfortable including it.
Form 3115 -When you file your return for the year the election is effective, you need to attach Form 3115, an Application for Change in Accounting Methods. You also have to send a copy of Form 3115 to the IRS national office. Because Form 3115 is a concoction of arcane questions, I highly recommend you consult with a tax professional who can help you complete the eight-page Form.
The Section 481(a) Adjustment
There`s an arcane aspect of the mark-to-market election that confuses many people, including knowledgeable tax professionals. The question is what you report as the section 481(a) adjustment when you file Form 3115 for the mark-to-market election. Here`s an explanation of this adjustment.
Purpose of the Adjustment - When you change your accounting method, it`s possible you`ll have some items that are either duplicated or omitted because they`re treated differently under the two accounting methods. For example, suppose you switched from cash accounting to accrual accounting at the end of 2002. In January, 2003 you paid an expense that relates to the previous year. You can`t deduct this amount under the cash method in 2002 because you didn`t pay it that year. Likewise, you can`t deduct it under the accrual method in 2003 because it relates to the previous year. The section 481(a) adjustment allows you to correct this type of problem. In this case, the adjustment would be an added deductionto make up for the fact that this item fell between the cracks when you changed your method of accounting.
Calculating the 481(a) Adjustment - The mark-to-market election requires you to treat the securities in your trading account as if you sold them for fair market value on the last day of the taxable year, with and resulting gain or loss reported as ordinary income or deduction. Under this method of accounting, you`re treated as if you sold your trading securities for fair market value at the end of the year. Your basis for the securities is adjusted for any gain or loss, with the result being that basis equals year-end value for any securities held at the end of the preceding year.
For the last year before the mark-to-market election takes effect, you`re still using the normal tax rules to report gain or loss. You don`t treat your securities as sold on the last day of the year. Yet under the mark-to-market system, which you`re using as of the beginning of the next year, your basis is equal to the value of the securities at the end of the preceding year. That creates the potential for duplication or omission of gain or loss.
Example: At the end of 2000 you held shares with $24,000 basis but value of $26,000. You made the mark-to-market election effective beginning in 2001, and ended up selling these shares for $30,000. You report $4,000 of gain on the sale of the shares, and in addition you have a $2,000 section 481(a) adjustment.
If you held securities at the end of the year preceding your first year using the mark-to-market method, your adjustment is the difference between the value of those securities at the end of the year and your adjusted basis for the securities. Tax professionals looking for authority on this point should review Rev. Rul. 93-76. Although this ruling deals with dealers rather than traders, it explains how the section 481(a) adjustment works in connection with a change to mark-to-market accounting.
*If you would like to learn more about how to properly set-up a trading business, and all of the tax strategies available to you, check out the Traders Accounting homepage.
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