Section 475 MTM Accounting
Section 475 MTM accounting allows traders to deduct trading losses in the current tax year.
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 with trader tax status (TTS) can avoid it by filing timely elections for business ordinary tax-loss treatment: Section 475 mark-to-market (MTM) for securities and/or 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).
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. The problem is that their trading losses may be much higher and not useful as a tax deduction in the current tax year. Capital losses first offset capital gains in full without restriction. After the $3,000 loss limitation against other income 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 from using Section 475 MTM right away?
Business traders qualifying for TTS have the option to elect Section 475 MTM accounting with ordinary gain or loss treatment in a timely fashion. When traders have negative taxable income generated from business losses, Section 475 accounting classifies them as 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 for the current tax year) can’t claim business ordinary-loss treatment for the current tax year. They will be stuck with capital-loss carryovers and onerous wash sale loss deferral rules will apply at year-end. A new entity set up after April 15 can deliver Section 475 MTM for the rest of the current tax year if the entity files an internal Section 475 MTM election within 75 days of inception. That breaks the chain and stops wash sales in the individual trading account. (Read more about these strategies in our content on entities.)
Ordinary trading losses can offset all types of income (wages, portfolio income, capital gains, 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 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 Section 475 MTM treatment at year-end, meaning you can defer unrealized gains on properly segregated investments. 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’re segregated or not. We generally recommend electing Section 475 on securities only, so you retain lower 60/40 capital gains rates on Section 1256 contracts. Far too many accountants and traders confuse trader tax status and Section 475; they are two different things, yet very connected.
For more in-depth information about Section 475 MTM, including many nuances to consider in making an election, read Green’s Trader Tax Guide. Our companion tax return examples guides shows example tax returns using Section 475.
Visit these other Trader Tax Status pages to learn more:
Business Expenses are far better than investment expenses.
How to Qualify — it’s nuanced and our golden rules help.
Employee-Benefit Plans — deduct retirement plans and health insurance premiums.
Defend it with the IRS — How to win when an auditor challenges TTS.