Avoid wash-sale losses and the $3,000 capital loss limitation and qualify for a 20% QBI deduction, states Robert Green of GreenTraderTax.com.
The most significant problem for investors and traders occurs when they cannot 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 Section 475 mark-to-market (MTM) elections for business ordinary tax-loss treatment for securities and/or commodities (Section 1256 contracts).
Profitable traders might also benefit from Section 475. If a TTS trader wants to be eligible for a 20% qualified business income (QBI) deduction, she should consider electing Section 475 ordinary income treatment. The QBI deduction is not allowed if the taxpayer exceeds a taxable income threshold because trading is a specified service business. (See more below).
Capital Losses vs. 475 Ordinary Losses
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 valuable as a tax deduction in the current tax year. Capital losses first offset capital gains in full without restriction. The rest are a capital loss carryover to the following tax year(s). Many traders wind up with little money to trade and unused capital losses. It can take many years to use up their capital loss carryovers.
What a tragic waste! Why not get tax savings from using Section 475 MTM right away?
Traders qualifying for TTS have the option to elect Section 475 MTM accounting with ordinary gain or loss treatment in a timely fashion. You can offset wage and other income with MTM ordinary losses, navigating around the capital loss limitation. When traders have negative taxable income generated from business losses, Section 475 accounting classifies them as net operating loss (NOL) carryovers.
Caution: Individual business traders who missed the 2021 Section 475 MTM election date (May 17, 2021, one-month pandemic postponement deadline, and June 15, 2021, for Texas, Oklahoma, and Louisiana under federal storm disaster relief) can’t claim this treatment for 2021 and will be stuck with capital-loss carryovers to 2022.
Taxpayers without a significant capital-loss carryover may want to consider electing Section 475 for 2022 by the deadlines of April 18, 2022, or March 15, 2022, for existing partnerships and S-Corps. (See 475 election procedures below.)
A “new taxpayer” (new entity) set up after April 18, 2022, can deliver Section 475 MTM for the rest of 2022 on trading losses generated in the entity account if it files an internal Section 475 MTM election within 75 days of entity inception. This election does not change the character of capital loss treatment on the individual accounts before the entity’s start date.
Section 475 Trades Are Exempt From Wash Sale Loss Adjustments
The election exempts the Section 475 transactions from wash-sale loss (WS) adjustments on securities, which would otherwise defer tax losses to replacement positions. If WS happens around year-end, it might create a phantom taxable income because it defers tax losses to the subsequent year.
Section 475 MTM allows current-year trading losses to be ordinary business losses rather than a $3,000 capital loss limitation. It generates significant tax breaks immediately, rather than being stuck with large capital-loss carryovers to subsequent tax years. Many traders enjoyed trading gains in 2020 and 2021, and tax-loss insurance was not essential.
However, 475 ordinary loss treatments might be crucial in 2022.
Section 475 MTM also reports year-end unrealized gains and losses as marked-to-market, which means one must impute sales for all open trading business positions at year-end using year-end prices. Many traders have no open business positions at year-end, anyway. They report the realized and unrealized gains and losses, like Section 1256, which has MTM built-in by default—but don’t confuse Section 1256 with Section 475. MTM treatment is what makes wash-sale losses a moot point.
Section 475 is Ideal for Securities Traders.
Securities traders usually elect Section 475 MTM, unless they already have significant capital-loss carryovers. Traders can’t offset MTM ordinary trading gains with capital-loss carryovers; only use capital gains (such as gains from segregated investment positions or Section 1256 contracts) in such a manner. However, suppose a trader generates significant new trading losses before April 18, 2022. In that case, she might prefer to elect Section 475 MTM for 2022 by that sole proprietor election date to have business ordinary-loss treatment retroactive to January first, 2022. The trader can form a new entity afterward for a “do-over” to use capital gains treatment and get back on track with using up capital loss carryovers. Alternatively, the trader can revoke the Section 475 election in the subsequent tax year.
Consider electing Section 475 on securities only to retain lower 60/40 capital gains rates on Section 1256 contracts.
Excess Business Losses and Net Operating Losses
Starting in 2018, The Tax Cuts and Jobs Act (TCJA) repealed the two-year NOL carryback, except for certain farming losses and casualty and disaster insurance companies. These TCJA changes mean NOLs are carried forward indefinitely (20 years before the TCJA changes), and the deduction of NOLs is limited to 80% of the subsequent year’s taxable income.
TCJA also introduced an “excess business loss” (EBL) limitation of $500,000 married and $250,000 for other taxpayers. The inflation-adjusted 2021 EBL is 524,000 (married)/$262,000 (other taxpayers) and 2022 EBL is $540,00 (married)/$270,00 (other taxpayers). Business ordinary losses over the EBL limits are an NOL carryforward.
The 2020 CARES Act suspended the EBL limitation for 2018, 2019, and 2020 and allowed five-year NOL carrybacks for those years. Taxpayers can recalculate the NOLs without the EBL limitation and file a carryback refund claim if it makes sense. For example, carry back a 2020 NOL to 2015 and any unused NOL to 2016 and subsequent years.
TCJA’s NOL and EBL rules applied again in 2021 and 2022.
20% Deduction on Qualified Business Income
TCJA introduced a new tax deduction for pass-through businesses, including sole proprietors, partnerships, and S-Corps. Subject to haircuts and limitations, a pass-through business could earn a 20% deduction on qualified business income (QBI).
QBI includes Section 475 ordinary income and loss and trading business expenses. QBI excludes capital gains and losses, Section 988 forex ordinary income or loss, dividends, and interest income.
Traders eligible for TTS are a “specified service activity,” which means if their taxable income is above an income cap, they won’t receive a QBI deduction. The taxable income (TI) cap is $429,800/$214,900 (married/other taxpayers) for 2021, and $440,100/$220,050 (married/other taxpayers) for 2022. The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for specified service activities. The W-2 wage and property basis limitations also apply within the phase-out range.
TCJA favors non-service businesses, which are not subject to an income cap. The W-2 wage and property basis limitations apply above the TI threshold of $329,800/$164,900 (married/other taxpayers) for 2021 and $340,100/$170,050 (married/other taxpayers) for 2022. The IRS adjusts the annual TI threshold for inflation each year.
Sole proprietor TTS traders cannot pay themselves wages, so they likely cannot use the phase-out range, and the threshold is their cap.
475 Election Procedures
Section 475 MTM is optional with TTS. Existing taxpayer individuals who qualify for TTS and want it must file a 2022 Section 475 election statement with their 2021 tax return or extension by April 18, 2022—existing partnerships and S-Corps file in the same manner by March 15, 2022.
Election statement. The MTM election statement is a short paragraph; unfortunately, the IRS hasn’t created a tax form for it. It’s a version of the following: “According to Section 475(f), the Taxpayer elects to adopt the mark-to-market method of accounting for the tax year ending December 31, 2022, and subsequent tax years. The election applies to the following trade or business: Trader in Securities as a sole proprietor (for securities only and not commodities/Section 1256 contracts).” If a trader expects to have a loss in trading Section 1256 contracts, he can modify the parenthetical reference to say, “for securities and commodities/Section 1256 contracts.” But remember, the lower 60/40 tax rates on Section 1256 contracts will no longer apply. If the taxpayer trades in an entity, he should delete “as a sole proprietor” in the statement.
Form 3115 filing. Don’t forget an essential second step: Existing taxpayers complete the election process by filing Form 3115 (change of accounting method) with the election-year tax return. Complete a 2022 MTM election filed by the April 18, 2022 deadline on Form 3115 filed with your 2022 tax returns—by the due date of the return, including extensions.
Submit Form 3115 in duplicate—one goes with Form 1040 filing, and a second goes to the IRS national office. There’s no fee for filing Form 3115, and the election is automatic. That means the IRS should not confirm this election statement or the Form 3115 filing.
Forms 4797 and 3115 include a section for reporting a Section 481(a) adjustment, which is required when making a change of accounting. The rest of the multi-page Form 3115 relates to tax law, code sections, etc. This adjustment converts your bookkeeping from cash to MTM on January first of the election year.
After filing their Section 475 election statement, some traders changed their minds and wanted to skip the Form 3115 filing. That’s wrong and incumbent on them to finish up the election process. If a trader doesn’t qualify for TTS, they can’t use Section 475, but that must be based on accurate facts and circumstances, and not on a whim. It’s essential to be consistent and credible with the IRS.
Internal Elections for New Entities
The Section 475 election procedure is different for “new taxpayers” like a new entity. Within 75 days of inception, a new taxpayer may file the Section 475 election statement internally in its records. The new entity does not have to submit Form 3115 because it’s adopting Section 475 from the start, rather than changing its accounting method. One way to file an internal resolution is for the taxpayer to send himself an email resolution (election), which has a timestamp for proof of timely election.
Individuals are “new taxpayers” only if they have never filed an income tax return before. A new trader is not necessarily a new taxpayer for a 475 election.
Election to Revoke Section 475
The IRS makes revocation a free and easy process, mirroring the Section 475 election and automatic change of accounting procedure for existing taxpayers. A taxpayer cannot re-elect Section 475 for five years after revocation.
Segregation of Investments
Suppose a trader holds investment positions in equities and trades substantially identical securities positions in equities or equity options using TTS and Section 475. During a tax exam, an IRS agent could recharacterize trades as investments, or vice versa, whichever suits them best. For example, the IRS could reclassify an investment position in Apple equity currently deferred for long-term capital gains into Section 475 MTM ordinary income at year-end. Alternatively, the IRS could recharacterize Section 475 MTM ordinary losses on Apple options as capital losses, triggering a $3,000 capital loss limitation.
Traders with overlap between investing and trading activity should consider ringfencing TTS/475 trading into an entity and conducting their investment activity on the individual level.
That solution would fix the above potential IRS problem.
475 Fixes Wash Sales with IRAs for TTS Trades
If there is an overlap in what you trade in taxable accounts vs. what you invest in IRAs, the trader must avoid triggering permanent wash-sale losses throughout the year. Suppose a trader takes a loss in a taxable account and buys back a substantially identical securities position 30 days before or after in an IRA account. In that case, the wash-sale loss disenfranchisement becomes permanent.
To avoid such overlap, traders can fix this problem with a “do not invest” list. One strategy is to trade equities and equity options in taxable accounts and invest in ETFs, mutual funds, and REITs in IRAs.
TTS traders can make a Section 475 election to do away with wash sales between taxable accounts and the IRAs, so overlap is not a problem.
Consider all IRA accounts for married filing joint, including traditional IRAs, Roth IRAs, rollover IRAs, and SEP IRAs. Don’t include qualified plans like 401(k) or solo 401(k) plans.
Most traders are unaware of the nuances of triggering permanent wash sales between taxable and IRA accounts. IRS rules for broker-issued 1099-Bs have a narrow view of wash sales; they call for wash-sale loss adjustments on “identical symbols” for the one account. Conversely, IRS wash-sale rules for taxpayers have a broader view: Calculate wash sales on “substantially identical positions” (between equities and equity options) on all individual brokerage accounts, including IRAs. Consider using trade accounting software compliant with IRS wash-sale rules for taxpayers.
Section 475 is a consequential election for TTS traders with many advantages; but first, consider personal circumstances and nuances.
Learn More from Robert Green at GreenTraderTax.com.