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> MTM  One of the biggest questions asked - other than "How do I make a
profit?" - is how do I file my taxes. As trading filing rules are a little more
complex than your simple 1040ez statement, FuturesKnowledge.com has put together a list of
informational suggestions with the help of GreenTraderTax.com that should guide you through this process.
Please note - we are not a certified accountant, therefore, you should verify all of your
tax questions with either your local or national government offices (AKA: IRS Knows Best!).
Mark-to-Market Accounting (MTM)
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The new trader tax laws of 1997, IRC Section 475(f),
allow Traders in Securities (475(f)(1)) and Traders in Commodities (475(f)(2)) to elect
mark-to-market accounting (MTM) by April 15 of the current tax year (not after the year
ends). The main effect of this new tax law is to convert capital gains and losses into
ordinary gains and losses. If you lose a lot of money trading, MTM will save your hide.
Mark-to-Market Accounting (MTM)
– a simple explanation
MTM is an accounting method that describes how a trader calculates their trading gains and
losses (the amount calculated) and how these gains and losses are reported on a trader's
annual income tax returns ("characterization" of income or loss).
Amount calculated
Mark-to-market refers to the procedure you follow at year-end, when you mark all your open
positions to market prices. In effect, you are inputting a sale of all open positions
(long and short) at year-end using the year-end market prices. On the first day of the
following year, you input the buy back of those positions at the same market prices. In
effect, you end up reporting on your tax return all "realized" and
"unrealized" gains and losses. MTM converts unrealized positions to realized
positions for tax purposes.
MTM is similar to the "accrual method
of accounting" in the sense that the economic reality – not just the cash
settlement, as would be done using the cash method of accounting – is reported on
your tax returns. MTM only applies to trading gains and losses – it does not apply to
a trader's business expenses, as the accrual method of accounting would relate to. A
trader may elect MTM for trading gains and losses and use the accrual method of accounting
for business expenses.
By default, all traders and investors use
the "cash method” of accounting for trading gains and losses, and their trading
expenses. If a trader in securities and/or commodities qualifies as "being in
the business of trading" (see trader tax status
page), then they may also elect to use MTM for their trading gains and losses.
MTM trading gains and losses differ from
the amount of gains and losses you would have using the cash method. The difference is the
year-end MTM unrealized trading gains and losses that are inputted as realized.
Characterization
MTM trading gains and losses are considered "ordinary gains and losses," and
they are reported on Form 4797 (Sale of Business Property). "Ordinary" is the
key word; it means that trading losses may be deducted in full against any type of tax
return income (ordinary, passive, investment, capital). Ordinary business losses (MTM
trading losses) comprise part of one's "net operating losses" (NOLs), which are
net business losses for the tax year. NOLs may be carried back up to five years for
immediate tax refunds (on Form 1045 or Form 1040X).
Ordinary MTM trading gains are taxed at
ordinary tax rates, which are the taxpayer's margin tax rates. Short-term capital gains,
using the cash method, are also taxed at ordinary tax rates, so there is no difference
between MTM and the cash method as it applies to gains. MTM would not apply to a traders
segregated investment positions (i.e., a joint investment account held with a
spouse), so one does not give up the opportunity to benefit from long-term capital
gains tax rates, which are significantly lower than ordinary tax rates (e.g., 20 percent
instead of 38 percent).
Election
You must elect MTM by April 15 of the current tax year (March 15 for calendar
corporations). For 2001, you had to elect MTM by April 15, 2001 with the filing of your
2000 tax return or extension. "New” taxpayers may elect internally, since they
don't file a tax return for the prior tax year. We offer all the resources you need in our
Guides on how
to elect MTM, the MTM election statement to use and other MTM tax strategies. Our Guides
also show you how to file your Form 3115 (Change of Accounting Method) and how to
calculate the necessary Section 481 adjustment (for the change in accounting method).
It’s important that you elect MTM properly, since your entire "tax loss
insurance" rests on this work.
Other tax points about MTM
Both MTM and cash method trading gains are not considered "earned income" for
purposes of self-employment taxes, retirement plan contributions and health insurance
deductions. Trading is a work-related activity, but certain loopholes under the tax law
clearly exempt traders from self-employment taxation. MTM traders are also exempt
from the wash sale
rules.
Securities traders should elect MTM
MTM is "tax loss insurance,” meaning you can deduct your trading losses
as ordinary losses rather than restricted capital losses. With the cash method, a trader
must carry over excess capital losses to the following tax year, as individuals are only
allowed to deduct a net capital loss of $3,000 per tax year. Capital losses may not be
carried back for individuals. Our firm has consulted with many hundreds of traders who missed the MTM election,
and they were very upset to learn they could not receive tax refunds in connection with
their trading losses.
Special Factors
There are many nuances to electing MTM – important strategies to follow and pitfalls
to be aware of. Our firm consults approximately one thousand traders each year on these
nuances, and we help them make the right decisions in connection with MTM. For
example, how do you handle a large capital loss carryover from the prior year if you want
to elect MTM for the current tax year? (MTM trading gains can not offset capital loss
carryovers.) How do you manage your year-end trading to increase your Section 481
adjustment and reduce your capital loss carryover? Many other nuances apply as well.
One good idea for electing MTM
If you have large unrealized losses on securities held going into 2002, elect MTM for 2002
by April 15, 2002. By doing this, your unrealized losses become part of your Section 481
(a) adjustment. This converts unrealized capital losses into ordinary losses. If your
Section 481 adjustment is more than $25,000, you must prorate the adjustment over four tax
years, in equal amounts, starting in 2002. Four years of ordinary losses may be much
better than a large realized capital loss subject to the $3,000 annual loss limit (if you
don't have capital gains to offset it against).
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