Understand Mark to Market Tax Treatment

02/08/2012 8:00 am EST

Focus: TRADING

Tax expert Michael Atlias explains this often misunderstood tax treatment traders can elect to use during tax preparation.

In recent Webinars and live events we have conducted, I often get questions about what the Mark to Market (MTM) accounting method (IRC Section 475 (f)) is and how electing MTM can affect your tax liability.

A simple explanation would be that MTM is an accounting method that describes how a trader calculates their trading gains and losses, and how these gains and losses are reported on a trader's annual income tax returns.

What Is MTM?

MTM refers to a year-end process where you mark all your open positions to market prices. Essentially, you are calculating the sale of all open positions at year-end using the closing price of the last day of trading in that year.

In effect, you are reporting on your tax return all “realized” and “unrealized” gains and losses, so consequently, MTM converts unrealized positions to realized positions for tax purposes.

The default accounting method for all traders and investors is the cash method for both your trading gains and trading expenses. Only those who qualify as a trader in securities status have the ability to elect MTM to report your trading gains and losses. Those who qualify as investors are disqualified from electing MTM.

See related: Trader Tax Status: Do You Qualify?

When to Elect MTM

You must elect MTM by April 15 of the current tax year. For 2011, you had to elect MTM by April 15, 2011 with the filing of your 2010 tax return or extension. For 2012, you can make the election by April 15, 2012 with the filing of your 2011 tax return.

Changing your accounting method from cash to MTM will require you to file form 3115 Change of Accounting Method. The Change of Accounting Method is automatic and does not require consent from the IRS.

Two steps are required when electing MTM. The first is electing it on time and the second is filing form 3115. Failure to file the election on time or in the proper fashion can result in substantial tax liability. You will also need to calculate and report section 481(a) adjustment on the form 3115 and on your tax return form 4797.

Section 481 adjustment is your unrealized gain or loss on securities held in your trading business as of the end of the prior tax year; the reason being that cash method traders only report realized gains and losses in the prior year.

We strongly recommend using a professional accountant that specializes in tax trading rules to assist you on making the election (visit www.otataxpros.com).

One strategy to avoid the hard deadline of April 15 is to set up a corporation or LLC, as they are considered to be "new” taxpayers and may elect MTM internally since they don't have to file a tax return for the prior tax year. It's important that you elect MTM properly since your entire tax loss insurance rests on this work.

What Are the Benefits of MTM?

MTM trading gains and losses are considered ordinary gains and losses. This is an amazing benefit, as it means that trading losses may be deducted in full against any type of income. Ordinary business losses can also generate net operating losses (NOLs). NOLs may be carried back up to five years for immediate tax refunds using form 1045 or 1040X.

By Michael Atlias of Online Trading Academy

Continue reading about Mark to Market tax treatment here.

Related Articles on TRADING