EDUCATION CENTER
GTT RESOURCES: MTM: MARK-TO-MARKET ACCOUNTING

The new trader tax laws of 1997, IRC Section 475(f), allow Traders in Securities (475(f)(1)) and Traders in Commodities (475(f)(2)) to elect mark-to-market accounting (MTM) by April 15 of the current tax year (not after the year ends). The main effect of this new tax law is to convert capital gains and losses into ordinary gains and losses. If you lose a lot of money trading, MTM will save your hide.

If you missed the MTM election deadline, consider our "single-member LLC" trader tax strategy explained in our Missed MTM section.

Good news! Check out our new "Advocacy campaign" to seek "retroactive" relief for all traders to use MTM. We need your help to enact this change. Click here.

Mark-to-Market Accounting (MTM) – a simple explanation
MTM is an accounting method that describes how a trader calculates their trading gains and losses (the amount calculated) and how these gains and losses are reported on a trader's annual income tax returns ("characterization" of income or loss).

Amount calculated
Mark-to-market refers to the procedure you follow at year-end, when you mark all your open positions to market prices. In effect, you are inputting a sale of all open positions (long and short) at year-end using the year-end market prices. On the first day of the following year, you input the buy back of those positions at the same market prices. In effect, you end up reporting on your tax return all "realized" and "unrealized" gains and losses. MTM converts unrealized positions to realized positions for tax purposes.

MTM is similar to the "accrual method of accounting" in the sense that the economic reality – not just the cash settlement, as would be done using the cash method of accounting – is reported on your tax returns. MTM only applies to trading gains and losses – it does not apply to a trader's business expenses, as the accrual method of accounting would relate to. A trader may elect MTM for trading gains and losses and use the accrual method of accounting for business expenses.

By default, all traders and investors use the "cash method” of accounting for trading gains and losses, and their trading expenses. If a trader in securities and/or commodities qualifies as "being in the business of trading" (see trader tax status page), then they may also elect to use MTM for their trading gains and losses.

MTM trading gains and losses differ from the amount of gains and losses you would have using the cash method. The difference is the year-end MTM unrealized trading gains and losses that are inputted as realized.

Characterization
MTM trading gains and losses are considered "ordinary gains and losses," and they are reported on Form 4797 (Sale of Business Property). "Ordinary" is the key word; it means that trading losses may be deducted in full against any type of tax return income (ordinary, passive, investment, capital). Ordinary business losses (MTM trading losses) comprise part of one's "net operating losses" (NOLs), which are net business losses for the tax year. NOLs may be carried back up to five years for immediate tax refunds (on Form 1045 or Form 1040X).

Ordinary MTM trading gains are taxed at ordinary tax rates, which are the taxpayer's margin tax rates. Short-term capital gains, using the cash method, are also taxed at ordinary tax rates, so there is no difference between MTM and the cash method as it applies to gains. MTM would not apply to a traders segregated investment positions (i.e., a joint investment account held with a spouse), so one does not give up the opportunity to benefit from long-term capital gains tax rates, which are significantly lower than ordinary tax rates (e.g., 20 percent instead of 38 percent).

Election
You must elect MTM by April 15 of the current tax year (March 15 for calendar corporations). For 2003, you had to elect MTM by April 15, 2003 with the filing of your 2002 tax return or extension. "New” taxpayers may elect internally, since they don't file a tax return for the prior tax year. We offer all the resources you need in our Guides on how to elect MTM, the MTM election statement to use and other MTM tax strategies. Our Guides also show you how to file your Form 3115 (Change of Accounting Method) and how to calculate the necessary Section 481 adjustment (for the change in accounting method). It’s important that you elect MTM properly, since your entire "tax loss insurance" rests on this work.

Missed the election deadline
If you missed the mark-to-market election deadline but are still interested in MTM, read about your options and available tax strategies in our Missed Mark-to-Market section.

Other tax points about MTM
Both MTM and cash method trading gains are not considered "earned income" for purposes of self-employment taxes, retirement plan contributions and health insurance deductions. Trading is a work-related activity, but certain loopholes under the tax law clearly exempt traders from self-employment taxation. MTM traders are also exempt from the wash sale rules.

Securities traders should elect MTM
MTM is "tax loss insurance,” meaning you can deduct your trading losses as ordinary losses rather than restricted capital losses. With the cash method, a trader must carry over excess capital losses to the following tax year, as individuals are only allowed to deduct a net capital loss of $3,000 per tax year. Capital losses may not be carried back for individuals. Our firm has consulted with many hundreds of traders who missed the MTM election, and they were very upset to learn they could not receive tax refunds in connection with their trading losses.

Special Factors
There are many nuances to electing MTM – important strategies to follow and pitfalls to be aware of. Our firm consults approximately one thousand traders each year on these nuances, and we help them make the right decisions in connection with MTM. For example, how do you handle a large capital loss carryover from the prior year if you want to elect MTM for the current tax year? (MTM trading gains can not offset capital loss carryovers.) How do you manage your year-end trading to increase your Section 481 adjustment and reduce your capital loss carryover? Many other nuances apply as well.

One good idea for electing MTM
If you have large unrealized losses on securities held going into 2004, elect MTM for 2004 by April 15, 2004. By doing this, your unrealized losses become part of your Section 481 (a) adjustment. This converts unrealized capital losses into ordinary losses. Starting with the 2001 tax year, all first year IRC § Section 481 (a) adjustments are reported 100 percent in the year you convert from the cash method to the mark-to-market accounting method (IRC §475). The only exception to this is the "de minimis rule," which now applies to positive adjustments only. Ordinary losses are much better than a large realized capital loss subject to the $3,000 annual loss limit (if you don't have capital gains to offset it against).

Caution - You are stuck with "built-in" capital loss
Please note that when a partner contributes an asset to a partnership where the asset has a "built-in" capital loss in the hands of the partner (i.e. the cost basis of the asset is more than the fair market value at the date of the contribution to the partnership), the loss from sale of the asset is still treated as a capital loss by the partnership if the asset is sold within five years of the date it was contributed to the partnership. This is true even if the partnership has trader status and has properly elected MTM. Internal Revenue Code Section 724(c) specifically prevents the conversion of “built-in” capital losses on security transactions to ordinary losses by contributions from a cash basis trader/investor to a trading entity that has properly elected MTM. This applies also to a LLC, including a single-member LLC. However, it does not apply to S-corporations

For more information about mark-to-market accounting, we suggest you purchase our trader tax guides.

If you have any questions, e-mail info@greencompany.com or call us.

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