What is a Mark-to-Market Trader? |
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A Mark-to-Market (MTM) Trader is a trader who has officially elected with the IRS to employ the Mark-to-Market method of accounting for his positions at the end of the year. The election is declared in a letter to the IRS filed with a "timely filed" tax return for that year.
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Mark-to-Market election must be filed with the IRS by April 15 of the year in which the trader wishes to switch to the Mark-to-Market accounting method. This means, that if you did not file this election by April 15th, , you will not be permitted to apply Mark-to-Market method to your tax return this year. You will able to file this election with your tax return this year and use MTM for the year .
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IRS Form 3115, Application for Change in Accounting Method is a form used for the Section 481 adjustment that may be required the first year a trader files under MTM accounting method.
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There are several important questions to ask yourself before electing MTM, that we will get to in a moment. First, let's discuss the implications of an MTM election.
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What expenses you can deduct?
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First of all, an MTM trader is truly in the business of trading! This means, that his trades generate no capital gains or losses - rather, all his transactions are reported on Form 4797. To him, winning trades are simply income, losing trades are a loss to be deducted from his income. He need not worry about the $3000 net loss limitation that applies to investors and traders. |
What about the Self Employment Tax?
Trader in Securities
You are a trader in securities if you are engaged in the business of buying and selling securities for your own account. As a trader in securities, your gain or loss from the disposition of securities is not taken into account when you figure net earnings from self-employment. However, see Dealer in Securities, earlier, for an exception that applies to section 1256 contracts. For more information about traders in securities, see Publication 550. Please note that this is relevant to the Mark to Market Trader, the "basic trader" still has capital gains, rather than "income".
Quoted directly from the IRS, Publication 533, "Who Must Pay Self-Employment Tax?", (emphasis added)
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At the same time, the MTM election means loss of the tax shelter on existing positions - the MTM trader reports not only his completed trades' income and losses, but also the unrealized income or losses on any positions open at the end of the year. This is where the common name of the election come from - the trader marks to market value his open positions at the end of the year and reports the unrelialized profits and losses in his Schedule C for that year.
Because his activities result in ordinary income or loss, an MTM trader with a loss for the year is able to deduct his loss fully against his other income, or against his spouse's income (in a joint filing). In addition, a net operating loss from his trading business can be carried back two years by re-filing for those years, and/or carried forward 20 years.
Because of the different tax rates on ordinary income and capital gains (especially long term), the MTM trader needs to ensure that his investments (if any) are segregated in a separate brokerage account from his daily trading, to ensure proper accounting. That way, the MTM trader can continue to take advantage on the long term capital gains tax rates on his investments.
Wash sale rules have no impact on the trader who has elected Mark to Market accounting.
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One important thing you need to remember before electing MTM accounting:
If you have accumulated net capital losses to carry forward from previous year(s), these are only deductible against capital gains.
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Once you switch to MTM accounting, all your future profits will be ordinary income - therefore you would not able to utilize your carryforward losses, unless you have other sources of capital gains.
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MTM election can only be revoked under rare special circumstances, so it not a step to be taken lightly. Please make sure this is appropriate for your situation.
In order to have MTM election in place for year , you must file the election in writing before April 16, . There is not specific form, rather a letter that must include: description of the election, specific business the election covers (such as Schedule C), and the first year that you used Mark-to-Market election in the past, or will use now.
You send this letter in to the IRS office at the same address where your tax return goes. It is a good idea to use certified mail with return receipt!
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It may be advantageous in some cases for a trader to consider incorporating. Because of the upfront costs (your time as well as your money), as well as annual costs and record keeping considerations, these are generally best utilized by traders who show consistent large annual profits.
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