Tax Issues for "Traders", Part II
Mark to Market Rules
By Roy Lewis
In Part I, we discussed some of the tax reporting differences between investors and traders, and even reviewed some of the requirements for "trader" status. If you haven't had the opportunity to read that article, I would suggest you do so, since it lays much of the groundwork you'll need to know to understand this article.
So, let's hit the ground running. I closed with the teaser statement that there are really two different types of traders: A regular trader and a Mark-to-Market (MTM) trader. Let's look closer at the MTM trader.
The Mark-to-Market Election
The Internal Revenue Code, Section 475(f), allows traders (but not investors) to make an election that allows them to "mark" their stock holdings to the fair market value (FMV) at the end of the tax year. If the election is made, all securities held by the trader are deemed to have been "sold" at the end of the tax year, and then immediately repurchased. This causes the trader to realize tax profits on stocks that haven't really been sold yet.
Example #1: Terri Trader, an MTM trader, bought 100 shares of Blowhardt Inc. in November 2000 for $40/share. On December 31, 2000, those shares are trading for $75/stub, and Terri still holds all of them. Because Terri is an MTM trader, she is required to recognize a GAIN on her 2000 tax return in the amount of $3,500 (100 shares @ $35/share). For tax year 2001, Terri's cost basis in those shares is then increased to $75/share, and any subsequent gain or loss will be predicated on that adjusted basis.
Why in the world would anyone want to make an election that would cause her to pay taxes on "paper" profits each year? For two very good reasons: Making the election will remove the annual $3,000 limitation on net capital losses and the wash sale rules no longer apply to the trader -- two very burdensome rules that traders love to avoid. Making the MTM election takes them completely out of play.
Example #2: Terri Trader, an MTM trader, just had an awful year. She bought high and sold low on a number of stocks. At the end of the year, she tallies her stock gains and losses and finds that she has much more in losses than gains. In fact, she finds that her losses exceed her gains by $22,000. If Terri was a "normal" trader, only $3,000 of those losses would be allowed as a deduction against other income this year. But, since Terri is an MTM trader, the entire $22,000 loss will be allowed, to reduce her other income.
Example #3: Terri Trader purchased 500 shares of Overpriced Corp. on December 10, 2000 for $90/share. On December 20, 2000, Terri sold those shares for $30/share. Then, on December 28th, Terri repurchased another 500 shares of Overpriced Corp. This is a classic "wash sale" and, under normal circumstances, the loss on the original shares would not be allowed for tax purposes. But, since Terri is an MTM trader, she can ignore the wash sale rules and claim the loss of $30,000 on the original trade. And, while she'll be required to "mark" her repurchased 500 shares to the market on December 31st, she'll not have to bother with any basis adjustment required by the wash sale rules and will be allowed a full deduction for her $30,000 loss.
Additionally, if you are an MTM trader, all of your trading activities are reported on Schedule C. All of 'em. Not just your trading expenses, but also your net trading income is reported on Schedule C. In effect, your Schedule D will no longer be required. But, as we discussed in Part I, even though you'll report all of your trading income under Schedule C, none of that income will be subject to Self-Employment taxes. Seems pretty simple, eh? But, how about all of the information reported to you (and to the IRS) by your broker on your year-end 1099B statement? Shouldn't that be reported somewhere?
This is one of the little administrative problems with the MTM election: Reconciling your Form 1099B to the tax return without the benefit of a Schedule D on which to report your stock sales. But this is easily overcome. You can use any reasonable method to complete the reporting, but these are my two favorites:
Again, any reasonable method will work. But you must remember that if you are an MTM trader, you'll report all of your trading income and expenses on Schedule C.
- Simply attach a statement to the tax return explaining that the gross proceeds reported on Form 1099B are not reported on Schedule D because they belong on Schedule C subject to the IRC Section 475 Mark-to-Market election.
- Complete Schedule D, but use it as an attachment to Schedule C, and provide a statement explaining that the net profit/loss on the Schedule D is being reported as income on the Schedule C. That will allow the IRS computers to "match" their 1099B records to your Schedule D, and will still allow you to report your net income on Schedule C.
Making the Election
If you determine that you're a trader (remember that this election is not available to investors), and you're looking forward to making the MTM election for the current tax year, you are required to file the appropriate election with last year's tax return or extension. Therefore, the last day to make your election for 2000 was April 17, 2000, for example.
[Note: There are special rules for "new taxpayers" that might allow the election after the normal deadline. Generally speaking, a new taxpayer is defined as a taxpayer for whom no federal income tax return was required for the year preceding the year he or she wants to make the MTM election. So, a new taxpayer could be a newly formed partnership, corporation, or Limited Liability Company. In addition, many tax pros believe that a "new taxpayer" would include individuals who are just beginning their trading business and had no stock trades in prior years. It is not within the scope of this article to discuss all of the possibilities available to make a valid MTM election. Just be aware that, as with virtually all tax laws, there are exceptions to the general rule.]
To make a valid MTM election, you'll have to follow the procedures set forth in Revenue Procedure (Rev. Proc.) 99-17. (You can search for this and other Revenue Procedures at, where else, www.revenueprocedures.com -- just enter the Rev. Proc. number in the search box.)
Boiling it down to the simplest of terms, to make the election for the current tax year, let's use 2002 as an example, you must:
As you can imagine, making the election can get a bit complicated if you are not familiar with IRS rules and regulations. Therefore, you might want to get some help with the election from a qualified tax pro. In fact, before you even consider making the election, you might want to discuss your entire tax situation with a qualified tax pro.
- Attach an election statement to either your tax return or extension request for the year preceding the year the election is first effective. So, if you want the election to be effective in 2002, you'll file your election with your year 2001 tax return or extension no later than April 15, 2002; and
- Attach a completed Form 3115, "Application for Change in Accounting Method," to your tax return for the year of the change. Form 3115 would therefore be attached to your 2002 tax return filed in April of 2003. You are also required to file a copy of Form 3115 with the National Office of the IRS. In addition to the instructions for Form 3115, you'll also want to review Rev. Proc. 99-49 for instructions on completing and filing Form 3115.
There you have it. The short (very short) course on taxes and trading. But... really... we hope you have read these two articles with simply a passing fancy and will never actually need the information -- kind of like the articles we wrote on penalties (ouch) and extensions. Only you can determine what is best for you -- gambling (sorry, I mean trading) or investing. All of us at the Fool hope you elect the latter, because we firmly believe -- and hope we've shown through our research and the results of our real-money portfolios -- that your financial well-being will be found in investing, not trading.