Think of this as a Trader Tax Loss Insurance Plan!
You can only claim Mark To Market Accounting IF you qualify for trader status. Not sure if you qualify for trader status? Refer to this post.
One of the biggest advantages of claiming trader tax status is the ability to elect mark to market accounting (IRC Section 475). The Mark to Market method has the effect of converting capital gains and losses into ordinary gains and losses. All open positions are priced as if they were sold on the last trading day of the year (marked to market) and then “bought back” at the same price on the 1st trading day in January. Your unrealized gain or loss is then recorded for tax purposes on Form 4797.
Advantages of Mark to Market Accounting
- No Wash Sales: Traders using mark to market accounting are exempt from the wash sale rule
- Losses are FULLY deductible: this is the biggest reason to make the mark to market election. Losses are converted into ordinary losses (not capital losses), so you are not restricted by the $3000 capital loss limitation. This allows a trader to deduct all losses in the year that they occur, provided there is other income to off set it. You can even carry back the losses to previous tax years!
- No change to self-employment tax exemption
Disadvantages of Mark To Market
- No Capital Loss Carryover: if a trader is carrying capital losses, electing mark to market will change the classification of the trading gains going forward. Gains will be ordinary gains and any capital losses cannot be used to offset those gains (capital losses only offset capital gains).
- Election is permanent: 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 IRS (good luck), 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.
How to make the Mark to Market Election
In order to make the mark to market election, a trader must enclose a statement of intent with the prior year’s tax return (or extension request) by April 15. For example, if you intend to switch to the mark to market method for 2021, you will enclose an election statement with your 2020 tax return by April 15, 2021.
Then you’ll need to fill out and send in Form 3115 (Change of Accounting Methods) with your tax return for the following year. For instance, if you elect mark to market for the 2021 tax year, you’ll fill out and send in Form 3115 with your 2021 tax return by the April 15, 2022 due date.
If you have any open positions on January 1 of the year you make the election, you’ll also need to calculate and report Section 481(a) adjustments on Form 3115. This “marks to market” any open positions you have at the time you make the switch. Any unrealized gains over $25,000 can be prorated over 4 years and any unrealized losses can be taken in full on the current year’s tax return.
Be careful when making the election to the mark to market method. If you make any mistakes or miss any deadlines on sending in the right forms, you will lose out on the mark to market tax benefits.
Does the Mark To Market election make sense for you? Have you accumulated capital losses over your trading career and finally reached your “break-through” year to where you have achieved profitability? Does the mark to market method make sense for you? No two traders are the same and there isn’t a one size fits all approach to making this election. If you need help schedule a 30 minute consultation to help determine if Mark to Market accounting is right for your trading business.