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Mark-to-Market IRS Election Scenarios

market to market IRS election

A mark-to-market election requires that a taxpayer recognize ordinary gains or losses at the end of a calendar year. This amount is the difference between the basis and the fair market value of the securities they hold. It’s basically an accounting method where the price or value of a security reflects its current market value. In other words, each security held open at the end of December is treated as if it were sold on the last business day of the year.

How Does the Mark-to-Market Election Work?

The mark-to-market election changes the character of a trader’s gains from capital gain to ordinary income. It also changes losses from capital loss to ordinary income loss. For a trader who makes this election, the $3K capital loss limitation doesn’t apply any longer. 

Typically, taxpayers who make this election profit from daily market movements in the prices of securities. They are not focused on profits from dividends, interest or capital appreciation. A big advantage to this is that since all positions are priced to year-end market prices, there are no wash sales to calculate or report. It also accelerates recognition of all gains or losses that had been deferred, but eliminates the opportunity to time the gain or loss in future years. 

Most who choose this method see it as a positive for simplified tax reporting or even reducing their taxes. However, many taxpayers are unfamiliar with mark-to-market and so may not take advantage of it. 

Having the ability to treat losses from the sales of securities as ordinary losses rather than capital losses could be a great opportunity if you’re eligible.

Who Is Eligible for Mark-to-Market Election?

Usually, day traders of stocks and bonds might apply mark-to-market. Keep in mind that the tax treatment of those who buy and sell securities are not the same for all taxpayers. It varies based on whether an individual is considered a dealer, an investor or a trader. 

Traditionally, the mark-to-market rules are applicable only to dealers. IRC Sec. 475 defines a “dealer in securities” as a taxpayer who regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business. This makes the securities owned by a dealer essentially inventory held primarily for resale. 

Once Congress expanded the definition to include those who regularly offer to enter into, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business, it included those who offer or hold themselves out to terminate security positions. This includes foreign currency transactions and interest rate swaps where things are not bought and sold but rather contracts are entered into.

Dealers and traders using mark-to-market benefit from losses offsetting ordinary income, while expenses are considered business expenses, which may be deductible.

Dealers Versus Traders

How do you distinguish between a “dealer” and a “trader”? Dealers earn money as middlemen, basically holding securities as inventory. They then buy and resell securities to consumers. So, their income is from services they provide. Traders, on the other hand, obtain profit from price fluctuations.

The easiest way to think about the difference is that traders typically don’t have customers, so their securities are treated as a capital asset. Stockbrokers, however, have shares that they sell to customers at a market price plus commission, which makes them dealers with inventory.

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What About Mark-to-Market for Investors?

The same rules concerning capital gains and losses apply to investors. The opportunity for ordinary losses is not available if the taxpayer is an investor. They report their gains and losses on Schedule D. Because “investors” are not carrying on a trade or business, their deductions are limited.  

For example,IRC Sec. 179 expense deductions are only allowed for property used in a business. Investor expenses that are deductible are seen as investment expenses. Usually, there is no confusion about whether someone is an investor or dealer. Investors never hold securities in inventory and do not make a profit from buying and selling securities to others. Investors also do not profit from commissions as dealers do.

The difference between a trader and investor is a little murkier, however. A trader’s gains and losses are reported on Schedule D, just like an investor. A taxpayer who is seen as a trader carries on a business without inventory or customers (as opposed to dealers), while investors are not seen as carrying on a business. 

The fact that traders are viewed as carrying on a business makes the treatment of expenses different compared to an investor. As an example, a trader’s margin account interest is not investment interest subject to limitation under IRC Sec. 153(d) but rather a business interest expense deductible without limitation. 

This enables the taxpayer who is a trader to deduct significant amounts of interest that might be limited to an investor. In addition, a trader might qualify for the home office deduction because the home qualifies for one of the exceptions under IRC Sec. 280A for business use. 

With a business, traders are also given the tax benefits of being able to set up a qualified retirement plan, which investors are not. Miscellaneous business expenses, such as management fees, courses on investing and travel to investment seminars, are deductible under IRC Sec. 162. For traders, all these “business” expenses are deductions to  gross income on Schedule C.

Traders who make Sec. 475(f) election can have their gains and losses treated as ordinary income or ordinary losses. This allows traders (who make the election) to avoid the limitation on the deduction of capital losses. In short, they can use losses to offset all other taxable income without limitation.

All this said, most taxpayers are considered investors and are locked into reporting their gains and losses in the usual manner. However, if a taxpayer can trade securities on a part-time to full-time basis and be considered a business, they can take advantage of numerous tax strategies like mark-to-market.

Can a Crypto Day Trader Elect Mark-to-Market?

Now for the million dollar question (quite literally): can crypto traders make the mark-market election? Right now, the answer is not 100% clear, unfortunately. It depends on if the crypto a taxpayer holds is considered a security or a commodity. Crypto traders could potentially elect mark-to-market if they have strong arguments that their crypto constitutes securities and their trading positions constitute commodities.  

In addition, is the taxpayer in crypto as an investor passively accumulating earnings and overseeing their investments, or are they engaged in a trade or business of selling investments? Taxpayers with Crypto positions could qualify for a Sec. 475 mark-to-market election if they can answer these questions. For more information on finding tax strategies specific for you or your clients, see the latest tax planning software technology.

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