EDUCATION CENTER
Section 475 MTM Accounting For Traders

The biggest problem for investors and traders occurs when they are unable to deduct trading losses on tax returns, significantly increasing tax bills or missing opportunities for tax refunds. Investors are stuck with this problem, but business traders can avoid it by filing timely elections for ordinary tax-loss treatment: Section 475 mark-to-market (MTM) for securities and Section 1256 contracts if elected. Section 1256 contracts include futures, broad-based indexes, options on futures, options on broad-based indexes and several other instruments (covered in Chapter 3).

Forex receives ordinary (non-business) loss treatment by default with Section 988; these traders can elect capital-gains treatment for forex on a contemporaneous basis.

By default, securities and Section 1256 investors are stuck with capital-loss treatment, meaning they’re limited to a $3,000 net capital loss against ordinary income. Capital losses first offset capital gains in full without restriction. After the $3,000 loss limitation against other income of any kind is applied, the rest is carried over to the following tax years. Many traders wind up with little money to trade and unused capital losses. It can take a lifetime to use up their capital loss carryovers. What an unfortunate waste! Why not get a tax refund right away?

Business traders have the option to elect Section 475 MTM accounting with ordinary gain or business loss treatment in a timely fashion. When traders have negative taxable income generated from business losses, Section 475 accounting turns the losses into unrestricted and unlimited ordinary business losses and net operating losses (NOLs). Caution: Individual business traders who miss the Section 475 MTM election date (April 15, 2013 for 2013) can’t claim business ordinary-loss treatment for 2013. They will be stuck with capital-loss carryovers and wash sale loss deferral rules will apply at year-end. A new entity set up after April 15, 2013 can deliver Section 475 MTM for the rest of 2013 if the entity files an internal Section 475 MTM election within 75 days of entity inception. That breaks the chain and stops wash sales in the individual trading account. (See our tax planning chapter.)

Ordinary trading losses can offset all types of income (wages, portfolio income, capital gains, passive income, etc.) for you and your spouse on a joint filing, whereas capital losses may only offset capital gains. Plus, business expenses and business ordinary trading losses comprise a NOL. Taxpayers can carry back NOLs two tax years and/or forward 20 tax years. It doesn’t matter if you are a trader or not in a carryback or carryforward year. Business ordinary trading loss treatment is the biggest contributor to tax refunds.

You need to qualify for trader tax status in order to use this Section 475 election. There are many nuances and misconceptions about Section 475 MTM, and it’s important to learn the rules. For example, you’re entitled to segregate investment positions that aren’t subject to MTM treatment at year-end, meaning you can defer unrealized gains. You can have the best of both worlds — ordinary tax-losses on business trading and deferral with lower long-term capital gains tax rates on segregated investment positions. The IRS doesn’t permit Section 475 MTM ordinary loss treatment on investment positions, whether they are segregated or not. Far too many accountants and traders confuse trader tax status and Section 475; they are two different things, yet very connected. Confusion leads to missed elections, overpayment of taxes and missed opportunities for significant refunds. Consult with a trader tax expert.................

This is an excerpt - the first paragraphs of chapter 2 - from Green’s 2013 Trader Tax Guide • Copyright © 2013