This comprehensive guide strives to dispel any confusion by clearly explaining what Mark-to-Market means as far as traders and investors are concerned, as well as the consequences at year end and when filing your taxes from trading.
It will also explain the special rules surrounding the IRS section 475(f) election - use of the mark-to-market method of accounting for securities traders, and how to report your MTM gains and losses on IRS Form 4797.
"Mark to market" or "MTM" is an accounting method where the price or value of a security reflects its current market value. As applied to taxes from trading it means that each security held open at year end is treated as if it were sold at fair market value (FMV) on the last business day of the tax year.
The net result is that you realize a taxable gain or loss on your holdings for that particular tax year, even though your position is still open. Normally, you would not realize a taxable gain or loss until you closed your position in a security. The year end closing price is then used to establish the cost basis of your holdings going into next tax year.
There are certain securities that by definition get marked to market at year end for tax purposes. These are considered IRC Section 1256 contracts by the IRS and include:
All other securities normally use the cash basis method of accounting where you do not realize a gain or loss for tax purposes until the year that you closed your position in that security.
Beginning in 1997 the IRS permitted active traders, who have qualified for "trader tax status" with the IRS and operate as a trading business, to elect a method of accounting called Mark-To-Market (MTM).
According to the IRS:
A trader in securities or commodities may elect under section 475(f) to use the mark-to-market method to account for securities or commodities held in connection with a trading business. Under this method of accounting, any security or commodity held at the end of the tax year is treated as sold (and re-acquired) at its fair market value (FMV) on the last business day of that year.
What this basically means is that all open positions at year end are "marked to market" or priced to year end market prices to close out the position on paper. Your open positions are still open, but now the year end prices become the cost basis of your open positions going into next tax year.
Many active traders find this election appealing as a way to make filing simpler — and possibly reduce their taxes. However, there are qualifications and an election process that must be followed. Please see the How To Elect MTM topic below for details.
There are two major advantages of electing MTM:
If you are an active trader in securities or commodities with a mark-to-market election in effect for the current tax year, then the following benefits can be yours:
For example, if you have a large unrealized gain at year end in one or more of your open positions, you are forced to close those positions (on paper) using the year end prices which increases your current year taxable gain. This is true whether you are long or short. Normally you do not realize gains until you actually close your positions, so be aware of this at year end if you have elected MTM.
You also must qualify for, and then make a proper timely election with the IRS enabling you to use the MTM accounting method.
IRS Publication 550 for tax year 2021, page 68 states:
To make the mark-to-market election for 2022, you must have filed an election statement no later than the due date for your 2021 return (without regard to extensions). The statement must be attached to that return or with a properly filed request for extension of time to file that 2021 return (Form 4868, Application for Automatic Extension of Time To File U.S. Individual Income Tax Return). The statement must have included the following information.
If you are a new taxpayer and not required to file a 2021 income tax return, you make the election for 2021 by placing the above statement in your books and records no later than March 15, 2022. Attach a copy of the statement to your 2022 return.
IMPORTANT: Do not file Form 3115 at the same time you make your MTM election, as it may cause you to lose your MTM status!
After making the election to change to the mark-to-market method of accounting, you must change your method of accounting for securities when you file your taxes for the first year using MTM accounting. You do this by filing Form 3115 - Application for Change in Accounting Method.
Form 3115 is filed the first year you file as MTM, for example: if 2022 will be your first year MTM, you would send the statement of election with your 2021 return, and Form 3115 would be filed with your 2022 tax return.
Form 3115 is also where you attach your section 481 adjustment - see How to Report Gains and Losses on IRS Form 4797.
Once you make the election, it will apply to the current tax year and all later tax years, unless you get permission from the IRS to revoke it.
MTM Election Deadline: Unless you are a new taxpayer, the election must be made by the due date (not including extensions) of the tax return for the year prior to the year for which the election becomes effective. So, if you have not made the MTM election by April 15 of the current tax year, then you will typically have to wait till next year to do so. Some exceptions may apply, please consult with a trader tax professional about your situation.
If you properly made the mark-to-market election with the IRS, you should report all gains and losses from trading as ordinary gains and losses on Part II of Form 4797, instead of as capital gains and losses on Schedule D. In that case, securities held at the end of the year in your business as a trader are marked to market by treating them as if they were sold (and re-acquired) for fair market value on the last business day of the year.
The instructions for Form 4797 state:
Securities or Commodities Held by a Trader Who Made a Mark-To-Market Election
Report on line 10 all gains and losses from sales and dispositions of securities or commodities held in connection with your trading business, including gains and losses from marking to market securities and commodities held at the end of the tax year (see Traders Who Made a Mark-To-Market Election, earlier). Attach to your tax return a statement, using the same format as line 10, showing the details of each transaction. Separately show and identify securities or commodities held and marked to market at the end of the year. On line 10, enter “Trader—see attached” in column (a) and the totals from the statement in columns (d), (f), and (g). Also, see the instructions for line 1, earlier.
Key steps explained:
Since all trades are priced to year end market prices and are therefore held one year or less, all of the MTM trades are by definition short term and are considered ordinary and are to be listed in Part II of this form.
There are seven columns in Part II as shown below:
Column (e) Depreciation is not used for the purposes of investments, only columns a-d and f-g.
All of the same trade matching rules involved in reporting trade history for capital gains and losses apply for MTM, so having an automated method of doing so can save you many hours of work.
TradeLog was designed to meet the tax needs of active traders in securities who have elected or are about to elect the mark to market (MTM) accounting method, or who trade section 1256 contracts.
In addition to automating the process of importing your trades from your online broker and matching them properly for attaching to your Form 4797, TradeLog provides the necessary mark to market accounting procedures and reports which greatly simplifies the filing of your trader tax return.
Please note: This information is provided only as a general guide and is not to be taken as official IRS instructions. Cogenta Computing, Inc. does not make investment recommendations nor provide financial, tax or legal advice. You are solely responsible for your investment and tax reporting decisions. Please consult your tax advisor or accountant to discuss your specific situation.